Tax Rises to Dent the Recovery, Pound Sterling Falls against Euro, Dollar

Picture by Andrew Parsons / No 10 Downing Street.

• Market rates at publication:
• GBP/EUR: 1.1630 | GBP/USD: 1.3778
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The British Pound was a laggard on Tuesday following the announcement of new tax hikes in the UK, a move the government said was required to pay for the health and social care systems.

The tax rises were however said by economists to be severe enough as to hamper the UK's economic rebound, and with foreign exchange markets focussed on relative economic performance this could count as a mark against the Pound.

The government expects to raise an additional £12BN annually from tax rises that include hiking National Insurance Contributions and a tax on dividends.

Andrew Sentance, Senior Adviser, Cambridge Econometrics, says the government risks repeating the mistakes of 2010 when the government hampered the recovery by raising VAT from 17.5% to 20%.

"Their successors - Boris/Sunak - risk doing the same by hiking National Insurance. Any tax rises should be delayed until 2024/25 at the earliest," says Sentance.

National Insurance would be raised 1.25 percentage points for both employers and employees while a tax on dividends will also be raised by 1.25%.

In the wake of Prime Minister Boris Johnson's address to Parliament the Pound-to-Euro exchange rate lost 0.28% to quote at 1.1622 and the Pound-to-Dollar exchange rate lost nearly 0.40% to quote at 1.3787.

Above: GBP/EUR hourly (top), GBP/USD hourly (bottom) as news of tax hikes are digested by the market.

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Declines were widespread suggesting there was an element of Sterling-specific negative sentiment in the market.

Samuel Tombs, Chief UK Economist at Pantheon Macroeconomics, says the tax hikes risk acting as fiscal brake to the UK's economic recovery.

"Markets' expectations that the MPC will raise Bank Rate in Q2 2022 look way off the mark, now that households are going to be hit by a tax increase in April that will reduce the average workers' tax-home pay by 1.2%," says Tombs.

The Pound's value is currently consistent with investor expectations for the Bank of England to raise interest rates in 2020, any delay to the move could therefore result in a repricing of the currency lower.

"We would guess the combination of fiscal tightening and party backlash may weigh on GBP," says Elsa Lignos, Global Head of FX Strategy at RBC Capital Markets.

The UK economy was expected to grow faster than its developed market peers in 2021 as it rebounded from the lows caused by covid lockdowns, but any headwinds caused by increased government taxes could prompt a reevaluation of the scale of the bounce back.

"Increasing National Insurance is essentially a tax on jobs. Given the economic challenges we face as we recover from the impact of Covid, and the lockdowns, I think this is the wrong policy at the wrong time," says Scott Gallacher, Director at Rowley Turton.

The UK government provided generous support to furloughed workers and some businesses during the pandemic, however this fiscal support will come to an end in September when the furlough scheme is finally wound down.

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Most businesses that received loans from the government will now already be paying them back.

"Now is not the time to be increasing National Insurance. It is going to be a difficult time for people anyway with the end of furlough, end of the Stamp Duty holiday and high inflation. The last thing we need at the moment is to be paying more tax. And that is what NI is, a tax," says Joshua Gerstler, Owner at The Orchard Practice.

Shaun Moore, tax and financial planning expert at Quilter meanwhile says the dividend tax will harm the UK's entrepreneurial spirit.

"There are hundreds of thousands of directors of limited companies who pay themselves an income through dividends. This is a group that were locked out of any financial support during the pandemic and are now facing the double whammy of seeing their income hit just as the recovery takes shape and they try to find their feet once again. Landlords also won’t face any additional tax hikes from the new levy," he says.