11 - 06 - 08

One swallow may not make a summer, but comment from the Bank of England in its latest Financial Stability Report that the worst of the credit crunch is over makes reassuring reading ...

One swallow may not make a summer, but comment from the Bank of England in its latest Financial Stability Report that the worst of the credit crunch is over makes reassuring reading. However, this should be viewed in the context of other economic news.

Sorting out the 10p tax rate debacle

A steady hand  and low taxes can help weather global financial turbulence

When Gordon Brown first announced that he would be lowering the basic rate of tax from 22p to 20p in his final budget (March 2007) he was clearly pitching for the leadership that he subsequently won (and may now regret having done so). Even then, some of us suspected that there would be problems ahead. But few could have foreseen that the way the change was delivered a year later by his successor would lead to one of the largest parliamentary revolts seen in recent years.

The subsequent volte face which led to a late £600 boost to the single person’s allowance (and a corresponding reduction of £1,200 of the level at which higher rate tax cuts in) has cost the Treasury £2.7 billion which a few weeks earlier it said it didn’t have. This ‘good news’ for millions of basic rate taxpayers will have to be paid for by borrowing; so the cost of trying (unsuccessfully) to win the Crewe and Nantwich by-election will be yet another burden on the taxpayer to be repaid at a later date.

This takes public sector debt within a hair’s breadth of breaching the Golden Rule that debt should be held at sustainable and prudent levels (estimated at 40% of Gross Domestic Product (GDP)). The Chancellor should only borrow to invest over the economic cycle, but this does not appear to worry him any more than it did his predecessor (who simply changed the start date of the economic cycle, when in trouble!). This time the solution is even more creative; get the Office for National Statistics to recalculate GDP, so that the limit is not breached. This may not matter in times of growth, but economic slowdown makes it more difficult to generate higher taxes without hiking rates.

Clawing back some of the money

Petrol and diesel are fast becoming a luxury

It looks as if the Chancellor will have to defer the fuel duty escalator that was to have been applied this autumn; but the cost of energy is still a matter of concern for consumers and businesses, as well as being a major contributor to inflation. However, asking UK-based oil companies to increase production will only help if speculators do not simply use this as an opportunity to make even more money. In theory, greater supply should cut prices; but in such a complex market, there is no guarantee that this will apply.

The good news is that non-OPEC countries such as Brazil, Azerbaijan, Russia, Canada and the US have recently been increasing production and OPEC is expected to do so this year, as well. This should help, although demand from ‘new’ economies is expanding rapidly.

Investor George Soros feels that the price of oil has many of the characteristics of a bubble and must burst. He may be right, but the question is “when”?

Washing the car may soon be all many people can afford to do!

Another method of collecting even more of our money has been through the promised introduction of more punitive Vehicle Excise Duty; from next year many cars registered after 1st March 2001 will be subject to much higher tax. In some cases (for example at 190 g/k, of CO2) the increase will be almost 24%, from £210 to £260.

The ‘excuse’ for the increase has been to influence decisions about what cars we drive, to encourage use of lower carbon emission engines. In theory, this form of social engineering may be acceptable, in terms of protecting the environment. In practice, it is a retrospective tax, since it applies to purchasing decisions made up to seven years ago, not to current and future decisions.

If you bought a new car in (say) 2006, which was in old tax band F, it will fall into new tax band J from next year; but short of selling the car and making a significant loss, there is nothing you can do about it. This is particularly galling to those who bought diesel cars in the belief that this was better for the environment (and are now paying much more for their fuel too). The new VED charges have nothing to do with influencing buying decisions; were this to be the case, it would apply only to new cars. It is about raising tax.

Markets (Data compiled by the Insurance Marketing Department Ltd.)

How long will the bear market run?

After a strong April, markets saw mixed results during May with the FTSE100 losing -0.56% over the month and the FTSE250, -0.72%. However in the UK AIM bucked the trend, gaining 4.99%. Elsewhere, the Dow Jones lost -1.42%, and the EuroStoxx50 -1.23%, while the Nasdaq100 gained 4.55% and the Nikkei225 3.53%. However, all the indices we track (except the FTSE250) are up over the past three months.

At least one leading investor is reported as feeling that the bear market has some way to go; but in historic terms, those with a long-term investment horizon need not be overly concerned. As has been well documented, oil prices soared again during March, adding 14.74% (after a spike of more than US$132) to end at US$127.78 per barrel. Oil now stands 88% higher than a year ago.

House prices continue to fall, but this is probably largely a correction following years of over-exuberance in the market. One effect of the credit crunch might be to help the buy-to-let market, as fewer first time buyers means a stronger rental market. Sterling lost ground slightly against both the dollar and euro, with the dollar also weakening against the euro. Perhaps in reaction partly to oil and equity markets, gold strengthened by almost 3% during May, to end at US$887.6 per ounce.

Interest rates and inflation

Wage inflation: the dog that has yet to bark

While interest rates have stabilised, largely because central banks fear boosting inflation as much as they do causing deflation, it is worth considering that, as Bank of England governor Mervyn King has warned, "for the time being at least the nice decade is behind us". This raises a number of questions, including whether an end to 16 years of growth and low inflation is really to be feared. It may be unpleasant in the short term, but over the longer term, it may be little more than a blip that shrinks into the distance, when seen in the rear-view-mirror of history.

More importantly, however, it encourages debate about the way the Bank of England seeks to manage inflation through the sole mechanism of interest rates and whether the existing measure of Consumer Price Index inflation of 2% plus or minus 1% is any longer valid. It has been argued that, to avoid high inflation and slow economic growth (stagflation), the Bank should look at a more appropriate measure of inflation; one that reflects precisely how real people – particularly pensioners, who often suffer most from higher energy costs - are affected.

The real threat is seen by some as ‘the dog that hasn’t barked’ yet; wage inflation driven by rising prices. At a time of relatively high employment, a lack of available (suitably skilled) replacement workers can make employers susceptible to demands for higher pay; this can cause cost-push inflation. There is some evidence that factory gate prices are already rising, which could be seen as a warning of higher consumer prices to follow.

Will insurance companies be forced offshore?

The recent budget, with its threat that some overseas earnings will now be taxed in the UK, has caused even some UK insurance companies to consider whether they need to relocate abroad, to territories where they will not be taxed so heavily. At a time when the country is so heavily dependent on invisible earnings from banking and insurance to buoy up lamentably low exports of tangible goods to sustain the current account (formerly the balance of payments), this could prove a major setback for the government’s ability to keep the economy under control.

Fortunately, the propensity for this administration to cave in when faced with well structured and logical opposition should make that out-turn less likely.

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