PRE-BUDGET REPORT INCREASES SPENDING, RAISES VAT

UNCLAS SECTION 01 OF 03 LONDON 002785

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN EINV UK
SUBJECT: PRE-BUDGET REPORT INCREASES SPENDING, RAISES VAT
AND NATIONAL INSURANCE TAXES, DELAYS CUTS

REF: LONDON 02783

LONDON 00002785 001.2 OF 003



1. (U) Summary. UK spending levels for 2010-11 will increase
slightly, by GBP 31 billion, up 2.2 percent from current
levels, as outlined in the HM Treasury's December 9
Pre-Budget Report (PBR). In his speech on the PBR to
Parliament, Chancellor Darling forecast a 4.75 percent
contraction for the UK economy, over a percentage point worse
than predicted in April, but he was optimistic the UK economy
would recover in 2010 and 2011. While outlining medium-term
plans to cut the deficit in half, Darling delayed a detailed
government spending review until after the 2010 general
elections. Opposition parties criticized Darling for not
specifically addressing the UK's ballooning debt in the PBR,
and called the report "not credible" and a "piece of
pre-electioneering." A controversial tax on bonus pay
(reftel London 02783) received considerable media coverage,
but it will not have a strong impact on government revenues.
Other revenue-generating tax measures included an increase in
the VAT and a hike in national insurance payments. Darling
also announced an increase in defense spending for
Afghanistan.

Economic Outlook Downgraded, But Still Optimistic
-------------- --------------


2. (U) Chancellor Darling projected UK GDP would contract
4.75 percent in 2009, over one percentage point worse than an
estimate of 3.5 percent he gave in April's Budget Report.
However, in a step critiqued by some economists, Darling
maintained his April prediction that the economy will grow
between 1 and 1.5 percent in 2010 and accelerate to a 3.75
percent pace in 2011. IMF and OECD projected a much more
modest 2 to 2.5 percent growth rate in 2011, while the Bank
of England expected a much more optimistic 4.1 percent rate.
Peter Spencer, chief economist to the Ernst & Young ITEM
Club, said medium-term forecasts had been stretched to
achieve the Chancellor's objective of halving the deficit in
four years. Price Waterhouse Coopers agreed with the
Chancellor's 2010 forecast, but projected a much slower
recovery beyond that. Darling expected inflation would spike
from 1.5 percent to 3 percent early next year and return to
1.5 percent by the end of 2010.

Debt Reduction Plans Don't Convince Markets
--------------


3. (U) In conjunction with the PBR, Darling introduced to
Parliament draft legislation and a plan to control the UK
deficit and net public sector debt. He said the government
deficit would hit a high of GBP 178 billion this year (12.6
percent of GDP),but the proposed legislation would require
the deficit as a share of GDP to fall every year from
2010-2011 to 2015-16. HMT forecast the following deficit to
GDP figures: 12 percent in 2010-11, 9.1 percent in 2011-12,
7.1 percent in 2012-13, 5.5 percent in 2013-14, and 4.4
percent in 2013-14. Darling expected net debt to GDP to
weigh in at 56 percent this year and climb steadily to a peak
of 78 percent of GDP in 2014-15 before starting to fall. He
maintained, however, that the UK's debt would be well in line
with figures in other G-7 countries, including France,
Germany and the U.S. The Chancellor also stated fiscal
tightening too soon would delay the recovery and bring on a
longer recession, which is in line with G-20 commitments.


4. (U) Analysts at the Institute for Fiscal Studies (IFS)
questioned, however, the debt forecast, which they said did
not include known factors, such as the extra costs of the
UK's aging population. While HMT forecasts the UK debt to
drop to 40 percent of GDP by 2032, IFS projected a higher
debt to GDP ratio of 60 percent for a generation unless
additional measures were taken. IFS said HMT's proposed
legislation to decrease the debt every year was not sensible
because its rules could be broken. IFS also said the overall
PBR had slackened the pace of fiscal tightening in the short
term, requiring greater tightening in later years. Moreover,
IFS economists believed future tightening would have to
include more tax increases or spending cuts.

Opposition Reaction
--------------


5. (U) Shadow Chancellor Osborne said the Government was not
being honest with the British people by deferring spending
cuts. He stated that the spending review was a missing
element of the PBR, and that the government was being
"dishonest" about the deficit. It was more of a pre-election
report than a Pre-Budget Report, he argued. The Liberal
Democrats also criticized the PBR, saying the chancellor had
"ducked the hard choices on spending and cuts."

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Market Reaction
--------------


6. (U) Markets were also unconvinced by the Chancellor's
efforts to reduce the UK's debt. The day after the PBR,
interest rates on UK gilts compared with German government
bonds widened and the yield on 10-year UK government bonds
rose by 0.14 percent to 3.8 percent, showing investors had
lower confidence in the government's ability to pay back its
debt and were demanding a higher return for holding UK bonds.
Prior to the PBR, credit rating agency Moody's said the UK
could lose its triple A rating for government debt if it did
not get public finances under control. After the report,
however, Moody's said UK and U.S. triple A ratings were
resilient for now, though a quick rise in interest rates
could test governments' abilities to finance their debt at
affordable rates.

Tax Increases Impact Middle Class and Rich
--------------


7. (U) A new tax on bank bonus payouts (see reftel)
dominated media coverage, but it is expected to have a
limited impact, raising revune of GBP 550 million. Far
greater impact will be felt from a further 0.5 percent
increase in national insurance rates beginning in 2011, which
is expected to raise GBP 3 billion per year. Though no one
earning under GBP 20,000 will have to pay the added amount,
the tax was heavily criticized by the Conservative Party and
the Confederation of British Industries as another tax on
employers and workers. The increase was on top of a 0.5
percent increase previously announced that goes into effect
in next year.


8. (U) The VAT will return to 17.5 percent on January 1,
following a one-year reduction to 15 percent as part of the
Government's fiscal stimulus program. The VAT should raise
an additional GBP 7 billion next year, according to HMT data.
Newspapers reported HM Treasury favored a further increase
in the VAT to 20 percent instead of national insurance rate
increases; such an increase would in HMT's view show the
government's commitment to control the deficit. The Prime
Minister allegedly overruled the increase. Another important
announcement was that the stamp duty holiday, under which
properties worth up to GBP 175,000 were not subject to
taxation, was scrapped in favor of a return to the previous
threshold of GBP 125,000. Mortgage industry actors feared
this could hurt the recovery of housing sales.

Pensions, Pay and Benefits
--------------


9. (U) Darling announced basic state pensions would rise by
2.5 percent in 2010 and child and disability benefits by 1.5
percent. Spending on schools would also rise 0.7 percent in
2011-12 and 2012-2013. Darling also announced free school
meals for some low-income families. To offset some of the
new measures, he said, however, contributions to public
sector pensions would be cut be GBP 1 billion per year and
public sector pay increases would be capped at one percent
for two years beginning in 2011.

Other New Measures: Defense, Small Business, and Environment
-------------- --------------


10. (U) Other measures in the PBR were aimed at defense and
development assistance, small business, and low carbon
growth. Highlights included:

-- A further GBP 2.5 billion for military operations in
Afghanistan, and a reaffirmed commitment that the UK would
meet the United Nations target of contributing 0.7 percent of
gross national income to official development assistance by

2013.

-- No increase in the 2010 tax rate for 850,000 small
businesses and a reduction of corporation tax to 10 percent
for income generated from patents in the UK.

-- A proposed Capital Growth Fund for small business
seeking loans

-- A six-month extension of the mortgage interest scheme
to assist those who had lost their jobs to cover mortgage
payments.

-- A tax-free credit of GBP 900 for home wind turbine or
solar panels and a tax exemption for electric cars from the
company car tax for a five year period.

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-- An additional GBP 200 million next year for energy
efficiency; GBP 160 million of public and private investment
into low carbon projects; and a further GBP 90 million in the
European Investment Bank's new 2020 fund, which will enable
euros 6.5 billion of finance for green infrastructure
projects.


Increased Short-term Spending Will Require Cuts Later
-------------- --------------


11. (U) The Chancellor postponed a Comprehensive Spending
Review, which will outline detailed program cuts in every
government department, until after the general election,
expected in early May 2010. He stated spending will grow
slightly in real terms next year totaling 2.2 percent or GBP
31 billion, and he said cuts will not begin until the economy
recovers in 2011. He further restated a commitment to
preserve front-line spending, which includes health, schools,
police, and international commitments to overseas development
assistance funding through 2013. Cuts in the areas not
ring-fenced would begin from April 2011, long after the
general election results. IFS estimated, a total of GBP 36
billion in cuts in government departments were needed,
however, to meet the government's deficit to GDP goals in the
three-year period between 2011-12 and 2013-14 of which GBP 15
billion have yet to be announced. IFS calculated that to
achieve the deficit reduction targets, public spending would
have to shrink by as much as 16 percent over three years in
unprotected areas such as defense, higher education, housing
and transportation.


12. (SBU) Comment: The PBR indicates the Labour government
believes it would be too soon to start winding down stimulus
measures and begin tackling the debt. Economic recovery in
the UK is still very weak, and might not yet be underway at
all, as evidenced by the worst-than-expected contraction in
GDP. How to manage the deficit will be the dividing line
between Labour and the Conservatives in the run-up to the
election, but specifics from either party will likely be
minimal so as to not risk voter backlash.

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