JP’s Journal: Government revenues and spending

It is always good to get feedback. So, I thought I would delve a bit more into the way the UK government spends our money. But let’s looks at the receipt side first.

The biggest earner, not surprisingly, is income tax. A temporary tax, introduced during the Napoleonic Wars, it has proved to be pretty resilient and brings in about 26% of total revenue. National Insurance adds another 18% whilst VAT completes the big three, coming in at 17%. Sin taxes and fuel together account for 11% whilst capital gains and corporation taxes contribute another 10%. Council tax represents about 8% whilst a miscellany of others makes up the balance (including the likes of stamp duty, bank levy and inheritance tax).

As the government tries to balance its books it is looking to increase receipts and reduce real spending. And this is where the problem lies. Increase taxes too much and the economy will stall, leading to lower tax receipts and higher welfare spending (the so called 'automatic stabilisers'). But cutting real spending is also a problem, given that welfare, health and education dominate. I wrote last week that the cost of servicing government debt was also rising, reflecting the higher Bank Rate and strong inflation. This gave rise to a question: if most government debt is fixed coupon, why is the servicing of government debt an immediate problem? Surely, it is only a small incremental cost as new debt is issued at higher rates? There are two separate issues to consider here.

First, about £600bn of UK debt is linked to Retail Price Index (RPI). An index linked gilt pays a coupon that is uplifted each year by the change in the RPI index. At the end of the term the capital repayment will reflect the change in prices since issuance – unlike a conventional gilt which just repays in nominal terms. Now, this uplift in redemption repayment is reflected in the government’s accounts at the time where the change in liability occurs. So, higher inflation now means both an uplift to income payments and also a higher accrued liability, reflecting the inflated repayment amount.

Second, we need to discuss Quantitative Easing (QE). The Asset Purchase Facility (APF) has bought just under £900bn of gilts as part of QE – with losses underwritten by the UK government. Over recent years the APF has made payments to the HM Treasury because the income received from the gilts (coupons) was greater than the interest costs of the loan taken to finance the purchases. This is now going into reverse. The cost of the loan is tied to Bank Rate – so as official rates rise so do financing costs. We are now in a situation where gilt coupon receipts are less than the cost of the loan. This difference is a cost to the government and is reflected in national accounts. This will be compounded as QE is reversed and gilts are sold at a loss – another cost to the government. So, higher inflation and rising Bank Rate will push up debt financing costs. With over two-thirds of spending allocated to welfare, health, education and debt service costs, and the challenges faced in these areas, it seems to me that taxes are not coming down any time soon.

But there is good news out there for the government. Energy prices are coming down which means that the planned energy price cap increase to £3,000 slated for April may not be needed. This feeds through to lower inflation estimates and more disposable income for consumers. Of course, there is a flip side. Interest rates may be kept higher and for longer. This may sound contradictory as inflation comes in lower, but it is the domestic side of inflation that may be the main concern, in particular the tightness of the labour market.

On the data front there was a mixed picture last week. UK inflation fell to 10.5%, in line with expectation, but the core rate remained stubbornly high at 6.3%, courtesy of higher service inflation. This backs up the argument for a 50bps hike at the next Bank of England meeting. Conversely, last Friday’s retail sales figures were poor, contradicting some of the upbeat messaging from retailers. Overall, December retail sales volumes fell 1.0% with consumer confidence falling further. This makes the case for a smaller rise. However it is sliced, rates are going up in February. With the tightening expected over the next six months we see Consumer Price Index inflation hitting the 2% target by mid-year 2024.

Bond yields were broadly lower last week with the US 10-year government rate ending below 3.5% although the UK 10-year yield was unchanged. There was a significant rally in Japanese government bonds, with the benchmark yield falling from 0.5% to 0.4%, reflecting the Bank of Japan’s position on Yield Curve Control – basically keeping 10-year rates around 0.5% or below. Implied inflation in most markets was unchanged with real yields moving in step with nominal rates. Similarly, there were few developments on the path of future rate hikes; the US market is still pricing a peak of 5% in June and cuts through H2.

On the credit front, sentiment remained positive with sterling spreads narrowing a bit and high yield spreads remaining at six-month lows. There continues to be a stream of issuance from financial companies but we did see the re-entry of EDF to the sterling market, after an absence of nine years.

Let’s go back to my main theme. The UK government is in a bind. Our 'net' tax base is narrowing, as highlighted by the Civitas report published over the weekend. However, demands on government spending will continue to grow. This means that we should get accustomed to relatively high levels of government borrowing and, consequently, the issuance of government bonds. The days when there were fears that the gilt market may disappear because our budget was in surplus (only the late 1990s) are long gone.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.