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Coronavirus – counting the cost to the UK economy

Investment Analyst Joseph Hill looks at the cost of the coronavirus on the government’s finances and their options for balancing the books in the years ahead.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

In recent months, time and time again the government have needed to get out the chequebook in response to the coronavirus. An economic crisis, only comparable to wartime, has meant there’s been unprecedented government spending and the Bank of England has pitched in too. They’ve put in plans to increase the amount of money in the economy and also made borrowing money as cheap as it’s ever been before.

This article is not personal advice. If you’re not sure if an investment is right for you, please speak to a financial adviser.

Limiting job losses has been a key focus in the current crisis. The furlough scheme, introduced by Chancellor Rishi Sunak has helped pay the wages of up to 9.5m workers at a cost of £31.7bn so far. But it’s been a price the government has been willing to pay to try and avoid a big spike in unemployment.

When workers lose their jobs and don’t earn as much, it means the government make less in tax revenue – it also means they have to spend more on welfare benefits. This double whammy effect on the state’s finances is one the Chancellor will be keen to avoid as much as possible.

Between April and June this year, tax payments received by HMRC were down 35%, while central government spending was up 40% compared to the same period last year. The effect of these changes can be seen below – it shows the country’s net debt accelerating sharply after a period of steady growth. Where spending outpaces tax revenues, the government needs to borrow to bridge the gap. The Office for Budget Responsibility recently estimated that the UK government would need to borrow £372bn this year to top up what it receives from taxation, and to meet public spending needs.

Public sector net debt (excluding public sector banks)

Scroll across to see the full chart.

Source: Office for National Statistics to 05/08/2020.

What does this mean for inflation?

In the short term, the impact of Covid-19 is likely to mean that general prices and the value of money (inflation) go down – driven by a decline in how much people are spending. But as the economy re-opens, the amount by which inflation recovers will depend on how quickly demand bounces back, and on how serious the ongoing supply disruptions are.

Some businesses might not be able to operate at previous capacity while restrictive measures like social distancing exist. But in the longer-term, there’s the potential for the wave of government spending to cause general prices to go up. Ultimately this will depend on how demand is managed.

Are tax rises or austerity on the horizon?

One option the government has to reduce its level of debt is to cut public spending, often referred to as austerity. However this is an unpopular approach and one that’s likely to be a vote loser. A recent YouGov poll showed that 47% of respondents preferred tax rises, with just 27% favouring cuts to public spending.

So tax rises could be a solution? Well yes, potentially, income tax, national insurance and VAT make up 60% of the government’s tax revenue and seem to have more support on the ground than austerity. But these are precisely the taxes Boris Johnson committed to not raising in the Conservative party manifesto.

Clearly, this was before the coronavirus swept across the world but a U-turn here might be seen as politically unpalatable. So employees might be saved from higher taxes, but the self-employed might not be so fortunate. Rishi Sunak hinted that they could pay higher national insurance rates in return for the state support they’ve received in recent months. There are a number of other taxes that the government might consider raising. However, one of which could be corporation tax, which at 19% is the lowest corporate tax rate in the G7 group of major developed nations.

Alternatively, the government could focus on stimulating demand and kick-starting a strong recovery in the economy to reduce its debt levels. Getting more people back to work and consumers back to their normal spending habits should see the economy grow and state finances improve. In the meantime the government will still have to pay the interest on its rising debt burden. But with interest rates so low by historical standards, this is unlikely to be a short term concern.

Difficult choices ahead

The government faces a difficult balancing act. Hike taxes or cut spending too soon and it could really damage the recovery and lock in years of slow growth. This wouldn’t help Boris Johnson’s levelling up agenda and would dent the chances of a v shaped resurgence. But ever growing debt is unlikely to be the government’s desired legacy and certainly isn’t a long term solution.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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