The EY ITEM Club Budget special report says the expected economic forecast from the Office for Budget Responsibility (OBR) will reveal little change in outlook in the past three months, leaving the Chancellor without a war chest ahead of the Budget.
Despite lack of wriggle room, the report argues a case for policy announcements on personal tax, rebalancing and housing, which must either be small scale or funded through savings elsewhere.
The Chancellor’s hand will be marginally strengthened, the report argues, by the OBR revising its UK growth forecast upwards to around 2.7 per cent in 2014.
This should allow the OBR to revise down its borrowing projections, throughout the forecast horizon, albeit only by £2-3bn a year.
The marginally stronger revenue forecast will come from better performances from income tax and corporation tax, but will be partially offset by weaker receipts from VAT, reflecting a cooling in the pace of nominal consumer spending growth.
Andrew Goodwin, senior economic advisor to the EY ITEM Club, said:
“Though we expect the OBR to publish a marginally better forecast, the revisions will be relatively small change in terms of public finances.
“If the Chancellor wants the OBR to continue to project a budget surplus by the end of the forecast horizon, he will have very little room for extravagance.
“This is a less than ideal situation given the proximity of the election.
“We do expect the forecasts to show borrowing more than £30bn lower than it would need to be to comply with the fiscal mandate, so he could reduce this buffer to fund giveaways.
“But having set great store on the forecast showing a return to budget surpluses, this would represent a major U-turn and so looks unlikely.”
The Chancellor may only have limited room for manoeuvre, but he will want to be seen to address the cost of living crisis.
Despite employment growth translating into rising earnings, and inflationary pressures continuing to ease, real wages remain more than 7.5 per cent lower than in 2007.
Political pressure is building to further increase the personal income tax allowance upwards of £10,000, but the EY ITEM Club says that further above-inflation rises are becoming increasingly costly and hard to justify.
An increase in the personal allowance of £100 more than inflation would cost £615m and would fail to benefit the lowest paid, many of whom have already been taken out of the income tax system by earlier increases.
Instead, the report points out that the lower paid would benefit more from a higher starting point for employees’ national insurance contributions, moving it closer to the income tax threshold.
Bringing it into line with the income tax personal allowance at £10,000 would add £254 to the pockets of someone earning £10,000, although such a move would cost more than £11bn to implement so remains highly unlikely.
In a bid to cool the London market, the report says the Chancellor could also increase the top rate of stamp duty for high value properties to help keep a lid on house prices.
A one per cent increase in the seven per cent rate, payable on sales worth more than £2m, would generate an additional £300m a year by 2016-17, and may reflect an acceptable compromise in place of a so-called ‘mansion tax’.
More generally, the report argues, a reform of the stamp duty system is long overdue, in particular the removal of the ‘cliff edges’ – already planned for Scotland – at the various thresholds which cause significant distortions to the market.
Furthermore, the stamp duty thresholds for the three per cent and four per cent rates have been unchanged since stamp duty on housing transactions was introduced in 2003.
This means that the average UK house price has moved from the one per cent band to the three per cent band, while more and more transactions have been dragged into higher bands.
Even if the Chancellor shuns wider reform, there is a strong argument for introducing indexation of the thresholds.
Had the three per cent threshold of £250,000 been indexed by CPI inflation it would now be £325,000, while had it been indexed by house price inflation, it would be £390,000.
The report says the Chancellor is also likely to take measures to address the UK’s housing shortage.
EY ITEM Club estimates that only 135,000 homes were completed last year, instead of the 200,000 needed each year to keep up with demographic changes.
The most obvious recommendations involve resolving rigidities in the planning system and selling off some of the Government’ sizable brownfield sites to house builders.
A more bold suggestion would involve the Government using its own low borrowing costs to fund a programme of house building, particularly on the sites it already owns.
Mr Goodwin added:
“The Chancellor’s interventions in the housing market have been well judged, helping to set in train a recovery in housing demand and, latterly, supply.
“Now is the time to build on this progress, ensuring that the recovery in house building continues to gain momentum and limiting the prospects of a housing bubble developing.”
The Chancellor has promised measures to help to rebalance the economy towards exports and business investment.
The report calls for the Government to extend its £250,000 annual investment allowance beyond its current deadline of the end of the year. Alternatively, the Chancellor could link more generous capital allowances to regional policy through the Enterprise Zones.
Promoting growth in these areas could help to offset the greater impact of austerity on the northern regions, while lessening the reliance on London to sustain the recovery.
Mr Goodwin said the energy industry would particularly benefit from pro-investment measures.
“The experience of the past few months has demonstrated the pitfalls of low investment in flood defences, but there is a very real risk that the UK could be sleepwalking into a similar crisis in energy.
“There is a strong case for financial incentives to encourage companies to invest. One solution could be to introduce capital allowances for investment in power generation projects, allowing companies to claim relief on a proportion of their investments on qualifying projects.”
Tim West, Tax Partner at EY in Yorkshire, concludes that the Chancellor must ensure that the good progress made on UK tax policy is not undone on Budget Day.
Mr West said:
“The UK is moving ever closer to achieving its ambition of creating one of the most competitive corporate tax regimes in the G20.
“Over the last five years, reductions to the headline rate of corporate tax, Controlled Foreign Companies reforms and the introduction of the patent box have turned the UK tax system into an asset once again.
“And it’s clearly working. We are aware of over 60 companies that are looking to complete headquarter relocations to the UK in the next 18 months.
“However after this intense period of change, companies are now looking for relative stability rather than headline grabbing corporate tax measures.
“Although it is one of the Chancellor’s last Budgets before the election, we would caution him against pulling any large, unexpected rabbits out of the ‘corporation tax’ hat – or rather the Red Box.
“Any such changes would need to be carefully targeted and designed to support the re-balancing of the economy.”