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UK: Truss government faces immediate fiscal credibility challenge amid tax, spending promises
By Eiko Sievert, Director, Sovereign and Public Sector Ratings
Elected Monday as leader of the ruling Conservative Party, so becoming the United Kingdom (AA/stable)’s new premier, Truss takes up office in unusually challenging economic circumstances.
With economic growth slowing and inflation in double digits as energy prices sky-rocket, and the pound weakening sharply against the US dollar, success in helping households to cope with the rising cost of living will define her premiership in the run-up to the next general election due in just over two years’ time.
One challenge specific to the UK which Truss’s government will have to grapple with in managing public finances is that inflation’s silver lining – in that it erodes the value of the stock of government debt – is considerably thinner for the UK. The Treasury has been a big issuer of inflation-linked bonds which make up around 25% of outstanding government debt, higher than other major European economies such as Germany (4%) and France (11%).
We have so far expected a gradual decline in UK public debt towards 84% of GDP by 2027 after a steep increase during the pandemic to 103% of GDP in 2020. As things stand, UK debt-to-GDP would remain well above expected 2027 debt levels for AAA-rated economies such as Germany (65%) and the Netherlands (47%), though lower than in some AA-rated peers such as France (115%) and Belgium (118%).
Truss promises wide range of reforms
Truss promises a wide range of policy changes, including significant spending commitments, tax reform and re-assessment of the country’s regulatory and fiscal frameworks.
One of these proposals is to pay off Covid-related government debt over a longer time horizon, which will add to the UK’s debt burden and is symptomatic of shortcomings in the UK fiscal framework. Unlike the more rigid frameworks in Germany or several Nordic countries, the UK’s framework has been frequently adapted in recent years in response to the economic outlook.
Proposed tax reforms would likely aim to at least contain the country’s tax burden. According to previous estimates by the Office for Budget Responsibility, this was on course to reach its highest level since the 1960s over the next few years, particularly due to the planned rise in corporation tax.
Changes to lower the tax burden are likely to include a reversal of April’s rise in national insurance contributions, scrapping planned corporation tax rises, and reviewing business rates, taxes on self-employed and inheritance taxes.
Tax revenues potentially at risk amid energy crisis
However, this could lead to a lower tax intake over the coming years if the cuts do not provide sufficient impetus for economic activity to offset the headwinds the UK economy is running into, from Brexit-related obstacles to export-led growth, high inflation, and surging energy costs plus the possibility of further pandemic-related strain on health services this winter. There has been little talk of cuts to public spending in non-essential areas to compensate.
To the uncertainty on the outlook for public finances there are concerns about the future of the country’s robust financial supervisory, economic and monetary governance frameworks which Truss plans to review. The UK’s existing sophisticated financial regulatory system and strong macroprudential governance framework under the Bank of England and the Financial Conduct Authority support the country’s credit ratings.
If the new government intends to reform the UK’s financial regulatory system, such as revisiting the Bank of England’s mandate or restructuring other key regulators, maintaining a sufficient degree of regulatory independence from political interference will be crucial.