Why Tax Hikes Risk Sending British Pound into the Slow Lane say Analysts

UK tax rises are "significant enough to slow the economic recovery next year" - Pantheon Economics.

Above: File image of the Chancellor Rishi Sunak. Image © HM Treasury, Gov.uk

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The UK government's decision to raise taxes will set back the recovery in UK household spending by as much as a year, according to new research.

The research finds the Bank of England will disappoint a plurality of investors expecting an interest rate rise in the second quarter of 2022, a disappointment that would likely pressure the Pound.

"Markets still expect the MPC to hike rates in Q2 2022, despite surprise plans to lift national insurance in April," says Samuel Tombs, Chief UK Economist at Pantheon Macroeconomics.

"The tax hike will defer a full recovery in households' spending to the second half of next year," he adds.

The British Pound proved vulnerable to the tax hike announcements, falling as Prime Minister Boris Johnson told the House of Commons the rises were needed to pay for additional NHS and social care spending.

The government said it would look to increase National Insurance contributions from both employees and employers by 1.25 percentage points, while also raising dividend taxes.

In March Pound Sterling Live reported the UK was the most generous "easers" amongst the developed world economies following Chancellor Rishi Sunak's budget announcement and that this could help the Pound.

But the taps are now being turned in the opposite direction.

Following the announcements a broad based weakness was observed in most major Pound exchange rates, suggesting the currency was subject to idiosyncratic pressures and further losses against the Euro and Dollar over coming days is possible.

The Pound-to-Dollar exchange rate fell back to 1.3787, compromising a short-term uptrend that it had been building since August 20 lows at 1.3602 were rejected.

The Pound-to-Euro exchange rate is meanwhile caught in a multi-day downtrend, in place since early August:

Above: GBP/EUR has been declining since early August.

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Analyst Mathias Van der Jeugt at KBC Markets says any weakness in Sterling stemming from these announcements might prove short-lived.

"Sterling slightly underperformed the euro, but for now the impact on sterling of the UK government raising taxes to fund the heath care bill remains limited," he says.

But Pantheon Macroeconomics have crunched the numbers and find the government's tax rises are likely to have consequences for UK consumer behaviour - an engine of the UK's services economy - going forward.

They are "significant enough to slow the economic recovery next year," says Tombs.

National Insurance contributions are levied on earnings above £120 per week, or £6.2K a year.

Pantheon Macroeconomics find that the average worker, who was paid £25.8K last year, will see their NICs bill rise by £244, reducing take-home pay by 1.2%.

"This hit won't be easily absorbed by households, given that the effective rate of income tax will be rising at the same time, due to the Chancellor's decision in the Budget to freeze the thresholds for the basic and higher rates at current levels for four years," says Tombs.

He adds households also will lose out indirectly from the equivalent 1.25pp increase in the rate of NICs paid by employers.

Pantheon Macroeconomics accordingly lower their GDP forecasts for the UK economy to 5.2% year-over-year from 5.5% previously.

Downgrades to UK economic growth matter for the Pound's outlook and leaves it potentially exposed at current levels.

After all, foreign exchange valuations tend to reflect the outlook for one economy relative to another and should the Eurozone and U.S. economies show better growth rates the Pound could shed value to the Euro and Dollar over time.

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But there are some emerging positive signs concerning the economy that could limit any newfound concerns stemming from tax rises.

Short-term surveys and data now suggest the economy could be rebounding from a summer lull.

New data shows a surge in workers returning to London in the week beginning August 06, while other UK cities also saw sharp rises in congestion.

Mobility is a key indicator watched by economists who see increases as being consistent with rising output.

Transport for London reported Monday commuter levels returned to pre-lockdown levels with 332K taps on the Tube, up 22% on last Tuesday, and 321K on buses, up 71%.

Early figures showed a 19% jump in passengers on the Tube network up to 9am, compared with last Tuesday (last Monday was a holiday), and 43% more on buses.

"Fundamentally, the UK economy is recovering well," says Alex O’Mahony at Citibank. "GBP is waiting for a catalyst to make a move. For example, GBP/USD has traded for the past 11 weeks in a rough range of 1.36-1.40. Our House view is for the pair to move back to the top end of the range, and so see it attractive to buy dips".

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UK economic growth stalled in June and July, with economists saying rising Covid cases had prompted consumers and business to adopt more cautious behaviour.

"On 19 July, the UK government removed all legal restrictions on social contact, but the spread of the Delta variant is likely to have slowed the pace of recovery in consumer-facing services," says Daniel Vernazza, Chief International Economist at UniCredit Bank.

Should consumers shake their concerns over persistently high cases of Covid, judging the risks to have been negated by vaccines, then the economy might accelerate once more.

"We remain positive on the GBP versus the USD, and also versus the EUR and the CHF. The economy is being opened up steadily, and the data flow is quite positive. We are most likely behind the peak of the delta variant wave," says Thomas Flury, Strategist at UBS.

It is meanwhile reported employers planned to make the fewest job cuts for seven years last month, suggesting that the end of the furlough scheme will not trigger a sharp rise in unemployment.

Figures from the Insolvency Service show that 12,687 jobs were earmarked for redundancy in August, down 11% since July.

Economists had feared a surge in employment in the final months of the year as businesses made redundancies following the ending of the government's furlough scheme in September.

But with businesses widely reporting acute staff shortages it appears the economy will absorb any new entrants to the jobs market.

Valentin Marinov, Head of G10 FX Strategy at Crédit Agricole said in a recent research publication the government withdrawal of labour market support would point to a more persistent underperformance in GBP vs both the EUR and the USD.

"We downgrade our near-term outlook for the GBP," said Marinov in a note published September 02.

Should the withdrawal of labour market support turn into a stimulus for the economy - given the difficulty businesses face in recruiting - what many had anticipated to be a drag on the Pound could prove to be supportive.