Contents. EY s view 2. EY ITEM Club Summer Budget Preview The economic and fiscal forecasts 7

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2 Contents EY is the sole sponsor of the ITEM Club, which is the only nongovernmental economic forecasting group to use the HM Treasury model of the UK economy. Its forecasts are independent of any political, economic or business bias. EY s view 2 EY ITEM Club Summer Budget Preview 5 1. The economic and fiscal forecasts 7 We expect minimal changes to the OBR s growth forecasts 7 and the borrowing picture may be better 8 2. The fiscal framework and overall policy stance 9 The new fiscal framework is problematic 9 and its impact on the fiscal stance is unclear 9 Fixing the rollercoaster should be the number one priority The Chancellor s policy options 11 Any giveaways shouldn t be too much of a surprise 11 including signalling tax cuts 11 Productivity efforts are unlikely to deliver anything transformative 12 Quick decisions around welfare cuts will be needed 13 as will detail on tax avoidance measures 14 The Chancellor does have options for removing the worst of the rollercoaster 15 EY 1

3 EY s view

4 EY View Business implications Mark Gregory EY Chief Economist As the first fully Conservative Budget since 1997 approaches, the economic outlook remains relatively bright. While risks remain, not least around the unfolding events in the Eurozone, the UK economy seems to be holding up relatively well, with consumer confidence reportedly rising to a 15-year high on some measures and retail sales remaining positive. So for business, the question is whether the Summer Budget will change the outlook and if so, in what ways. As this EY ITEM Club Summer Budget Preview points out, the new fiscal framework could impose significant risks to future economic growth, clearly bringing potential implications for business. However, alongside the possible negatives, there are also several positives to consider as the Chancellor fine-tunes his proposals. The first big positive from the business point of view is the opportunity for a renewed focus on productivity. The UK economy s weak productivity has been widely regarded as a puzzle for the past couple of years, and the Summer Budget may provide a catalyst for action to do something about it. Essentially, the new fiscal framework needs to accommodate an extra 32bn of capital spending. At the same time, the Government wants to boost productivity in the private sector. To contribute towards both goals, the Chancellor could encourage businesses to invest by increasing investment allowances, potentially accompanied by further additional support for manufacturing or exports. The resulting higher productivity and exports would foster progress toward a surplus without much risk to the economy. Other options to stimulate investment might include action on business rates and a renewed war on regulation and red tape. But as ever, questions and uncertainties arise. As this report highlights, efforts to improve productivity are unlikely to deliver anything transformative, at least in the short term. A further question is around where the money will come from to fund all this especially at a time when some areas of government spending that could help boost productivity are facing hefty cuts. The second big positive for business is the prospect of tax reductions to boost consumer spending. While the Summer Budget will see aspirations predominate over actions on the tax front, with any sizable tax reductions held back for now by the need to prioritise deficit reduction, personal tax cuts remain on the agenda for later in the parliament. And more generally, rising consumer spending possibly supported by a rebound in household borrowing will play a role in helping to fulfil the new fiscal framework. Business needs to balance these positives against the related risks. One is that the fiscal framework could reduce business confidence, making companies less rather than more likely to invest. Another is that welfare cuts could have the effect of boosting business costs, if wages have to rise to compensate for the impact of welfare cuts. At the same time, there s a risk that welfare reductions could also act as a drag on consumer spending, impacting consumer-facing businesses. But overall, with the economy remaining on track ahead of the new government s post-election Summer Budget, there are plenty of reasons for businesses to be optimistic albeit still cautiously so.

5 EY View Tax Viewpoint Chris Sanger EY Global Head of Tax If we look back through history, we should be expecting a tax-grab Budget on 8 July. The first Budget after an election has traditionally been used by past Chancellors as an opportunity to build up the Government s coffers, with a view to spending that money close to the end of the Government s term. However, the Chancellor could choose to resist the temptation. The EY ITEM Club reports that the economic background is little changed from where we were at the last Budget in March. Also, for the Chancellor, this is his first truly Tory Budget so he ll want it to be received and remembered positively. What s more, he s already limited his own room for manoeuvre in terms of any tax increases. The fiveyear tax lock announced during the election campaign constrains income tax rates, National Insurance rates, and the level at which NI drops down to 2 percentage points. It also constrains VAT rates, and what qualifies for the reduced rates of VAT. So there ll be no return to the omnishambles Budget of 2012 with the now infamous pasty tax. Given this background, will the Chancellor approach this Summer Budget humming Summertime, and the taxing is easy? Or will he be thinking of giveaways? The answer is likely to be a little of both. Given his new tighter fiscal framework and continued emphasis on addressing the deficit, he won t want to do much that reduces the tax take. But he will be looking to be generous in specific areas. Where might he be casting his eye? One area that could do with some help is manufacturing. As things stand, the Annual Investment Allowance is due to reset from its 500,000 level back to just 25,000 and he s already said he s going to increase that to somewhere substantially above 25,000. This may well be something that he pulls out of his hat on the day. He may also decide to announce an allowance for infrastructure more widely. The 500,000 level is great if you re investing up to that amount but if you re investing in a really large infrastructure project, that s just the first stage. Aside from possible giveaways, where might the Chancellor look for new revenues to help balance the books? Here he may be running the rule over the various elements that make up the tax base and looking for particular reliefs that can be removed without breaking the tax lock. Here he has form, as he s already decimated some of the pension tax reliefs for higher earners, with the commitment to further reduce the pensions relief down to 10,000 for those earning 210,000 or more. However, whatever revenue-raising measures he reveals this time, there s no doubt the Chancellor wants history to remember him as a tax-cutter rather than a tax-raiser. He s already tested the waters by floating a reduction of the 45% income tax rate down to 40%. That may be a step too far this time. But stranger things have happened! Economics for Business EY provide economic insight and analysis to help businesses understand the economic environment in which they operate both in the UK and in the context of the global economy. Read our latest economic reports: ey.com/uk/economics Click here for more info on our Tax Summer Budget activity. Follow us on Follow our Economics for Business blog: Subscribe to our EY UK&I Economics for Business YouTube channel

6 EY ITEM Club Summer Budget Preview

7 Highlights Highlights The relatively short period of time that has passed since March s Budget means that any changes to the Office for Budget Responsibility s (OBR) economy forecast are likely to be small. The economy is now known to have had greater momentum entering 2015 than assumed in March. But the latest outturn for growth in Q1 is substantially weaker than the OBR s assumption. These factors are likely to largely offset one another, leaving the Budget forecast close to March s projections of 2.5% GDP growth for this year and 2.3% in The OBR may deliver good news for the Chancellor on the public finances. The latest outturn for public sector net borrowing (excluding public sector banks) for is 89.2bn, 1bn lower than the OBR s Budget forecast. And while very early days, there is evidence that the OBR may have erred on the side of caution with regards to its forecasts for tax receipts in The path for fiscal policy over the parliament will be influenced heavily by the new fiscal framework which Mr Osborne will elaborate on at the Budget. The framework will entrench a permanent commitment to run a budget surplus in normal times, but what this means and the horizon over which the commitment will operate are lacking. A short horizon could entail an even tighter fiscal squeeze than currently planned, to the detriment of the economy. But the Chancellor is likely to tailor his new rule to ensure that no change in the overall fiscal stance is required. In terms of potential Budget announcements, the Conservative election manifesto, the Queen s Speech and the Chancellor s Mansion House speech all offer pointers. But with politics suggesting that giveaways will be weighted towards the latter part of the parliament and the Government faced with meeting its surplus commitment, promises are more likely than pounds. That said, the Chancellor may take some baby-steps toward meeting manifesto pledges around raising the income tax-free allowance and the threshold for paying the 40% rate. But a still sizeable fiscal deficit and difficult announcements around spending cuts suggest that the government will put its more contentious goals, including a new inheritance tax allowance, aside for now. Meanwhile, Mr Osborne is set to reaffirm the importance of boosting UK productivity growth. But a potentially potent means of raising the efficiency of the economy extra public spending on infrastructure is unlikely given that the Chancellor intends to move investment spending inside his new fiscal rule. Further devolution of powers to English cities will be highlighted and there may be support for private sector investment via a higher Annual Investment Allowance. As far as any takeaways are concerned, Mr Osborne will need to finally put some flesh on the bones of the oft-talked about 12bn reduction in welfare spending by A commitment to protect most pensioner handouts as well as child benefit has severely restricted the Government s room for manoeuvre, with low-income working households set to suffer if the cuts do go through. A watering down of the 12bn goal by shifting the target date further into the future is possible. The Budget may provide some details on where further savings in departmental spending will arise, and how they can be reconciled with the Tory manifesto pledge to raise NHS spending by an additional 8bn by the end of the parliament along with the Government s plans for an extension of free child care and pre-existing commitments around higher education and social care. But in determining the timing of cuts, the choice of timeframe for the new fiscal framework will once again be crucial. The full details of departmental spending plans will probably have to wait until the autumn s Comprehensive Spending Review. In terms of tax-raising measures, the Government s tax-lock commitment rules out any increase in the headline rates of income tax, VAT or NICs. But a reduction in the generosity of pension tax relief for those with an income of above 150,000 per year is on the cards. And the Chancellor may seek to extract more revenues via a rise in fuel duty and by restricting some income tax reliefs. EY 6

8 EY ITEM Club Summer Budget Preview There was always a strong probability that 2015 would see a second, post-general election, Budget, given the differences of view on fiscal policy within the previous coalition. However, right up until polling day, it had looked very unlikely that this would be a Budget presented by Mr Osborne against the backdrop of a Conservative majority government. So 8 th July s set-piece event provides the Chancellor with an unexpected opportunity to push ahead with policies which had been vetoed by the Conservatives erstwhile Liberal Democrat coalition partners. This Special Report starts by looking at where the Office for Budget Responsibility (OBR) may make changes to its economic and fiscal forecasts, which will be published alongside the Budget. We then move on to assess what the Chancellor might choose to announce in his statement. 1. The economic and fiscal forecasts We expect minimal changes to the OBR s growth forecasts The short period of time that has passed since March s Budget means that any changes to the OBR s economy forecast are likely to be small. On the one hand, largely due to revisions to the methodology for estimating construction output, the ONS has revised up its estimates of growth in late-2014, meaning that the economy had greater momentum entering 2015 than previously believed. But conversely the latest outturn for growth in Q1 of 0.4% is substantially weaker than the OBR s assumption of 0.7%. These factors are likely to largely offset one another, leaving the forecast close to March s projections of 2.5% GDP growth for this year and 2.3% in UK: Comparison of GDP forecasts % year 3.0 These projections are bang in line with the average Source : EY ITEM Club, OBR, HMT of independent forecasters surveyed by HM Treasury in June, though as we argued in our April forecast we believe that they are relatively cautious and could easily be exceeded. 1 In particular, we think that, the risk of Grexit notwithstanding, the OBR is being overly gloomy about prospects for the Eurozone (forecasting GDP growth in 2015 and 2016 of 1.2% and 1.4% respectively, compared to our prediction of 1.6% and 1.8%). Meanwhile, one of the key factors underpinning the OBR s weak forecast is their view that the UK has relatively little spare capacity just 0.7% of potential output at the end of 2014 and that the economy s ability to grow over the coming five years is much more limited than it was prior to the financial crisis. Indeed, the OBR s estimate of the level of potential output at the end of fiscal year is around 14% lower than that implied by an extrapolation of the 2008 Budget forecast. While we agree that the financial crisis is likely to have caused some damage to the productive potential of the economy (although whether such damage is irredeemable is a much more tenuous view), the literature on previous crises suggests that these typically saw less damage to potential output growth than the OBR s forecast assumes. 2 A key feature of the OBR s forecasts over the past five years has been the expectation of a sharp rise in the household debt-to-income ratio over the forecast horizon. Indeed, the official forecaster s March projection showed this ratio surpassing its previous peak by the end of the decade. This has been used by many commentators to make dire predictions of what will happen once interest rates start to rise. However, in our view this forecast is implausible. The OBR s March forecast also suggested that low inflation and rising real incomes will be reflected in a high saving rate rather than consumption, which is ITEM Club (Apr) OBR (Mar) HMT consensus (Jun) EY ITEM Club Spring Forecast, April 2015, full-report.pdf 2 See Table 4.1 (page 74) of the IFS Green Budget, February 2014, EY 7

9 inconsistent with rising levels of indebtedness. Furthermore, the experience of the past five years has been that households have behaved in the opposite manner to that expected by the OBR, continuing to deleverage rather than increasing their levels of indebtedness. This has forced the OBR to continually delay the point at which they expect the household debt ratio to start rising again. And even if households did rediscover an appetite for debt, such a large increase in indebtedness could only realistically occur through the housing market. But the OBR s forecast shows neither the substantial pickup in house prices nor transactions that might typically be associated with such an aggressive expansion in mortgage lending. And it is highly questionable whether the banking sector would have the capacity, or the appetite, to finance such a rise in household debt. UK: OBR forecasts for HH debt-to-income ratio % of disposable income 180 Budget11 Budget12 Budget13 Budget14 Budget Source : EY ITEM Club calculations using OBR forecasts UK: Household debt-to-income ratio % of disposable income OBR ITEM Forecast Source : EY ITEM Club, OBR and the borrowing picture may be better The OBR should have some good news for the Chancellor on the public finances front. The latest outturn for public sector net borrowing (excluding public sector banks) for is 89.2bn, 1bn lower than the OBR s Budget forecast. And while it is very early days in terms of , with just two months of data available, the OBR may have erred on the side of caution with regards to its forecasts for tax receipts. Strong consumer spending is feeding into healthy VAT receipts, while the recent acceleration in wage growth has underpinned better growth in income tax and national insurance revenues. So the OBR may nudge up its forecast for revenues in and push down its borrowing forecast for the same year from 75.3bn to closer to 70bn. Beyond this year it is unlikely that the OBR will make many changes to its forecasts at this stage, although in common with our views on growth, we think that, in general, the OBR is too gloomy in its expectations for revenues and that there is a good chance that they will be exceeded. This, in turn, would allow the Chancellor to relax his austerity plan, although it is likely to take several years for this scenario to play out and it will not affect the Chancellor s fiscal options for this Budget. In March the Chancellor had benefitted from the plunge in forward rates for gilt yields which, along with a lower profile for inflation, reduced the forecast for spending on debt servicing by 9bn in This time around developments in financial markets are likely to push the forecast in the opposite direction. As it has become clearer that very low rates of inflation or in some cases deflation around the world are unlikely to become entrenched, financial markets have become less bearish and forward rates for gilt yields are up by around 30bps compared with the assumption used in the OBR s March forecast. The OBR s ready reckoner suggests that such a difference in gilt yields should increase the UK s debt interest costs by around 1.2bn by , with the costs steadily rising through the forecast period. These higher debt servicing costs will mitigate the impact of the in-year departmental savings that the Chancellor announced at the beginning of June. These measures were set to reduce spending by around 3bn a year across the forecast horizon, so the net effect of these two contrasting forces will be to reduce borrowing by just under 2bn a year an amount which is not to be sniffed at, but which EY 8

10 represents a mere drop in the ocean compared with the degree of fiscal consolidation that the Chancellor has suggested he plans to implement. 2. The fiscal framework and overall policy stance The new fiscal framework is problematic The Chancellor s speech will no doubt make much of the new fiscal framework that he has said will be presented alongside the Budget. In his Mansion House speech on 10 June, Mr Osborne announced that a new fiscal rule would entrench a permanent commitment to run a budget surplus in normal times, with Sweden and Canada put forward as examples of good practice in this area. 3 The speech was conspicuously light on details about how the framework would actually work, but it appears likely that the government will replace the existing fiscal mandate which targets balancing the cyclically-adjusted current budget over a rolling three-year timeframe with a target of achieving a surplus on the cyclically-adjusted net borrowing measure. As this involves bringing investment spending inside the budgetary constraint, it would represent a tightening of the fiscal rules. In our view there are a number of serious problems associated with this new fiscal UK: OBR forecast for sectoral balances % of GDP Net saving framework. On a practical level, if, as we expect, Overseas 8 the Chancellor s normal times are judged in Government 6 Household relation to the output gap, a concept which cannot 4 Companies be estimated with any certainty, policy mistakes 2 could be triggered. If the OBR were too pessimistic about the degree of spare capacity in the economy 0 as we believe it is now then the outcome will be -2 an unnecessarily tight fiscal squeeze. Moreover, a -4 surplus commitment implies more control over the -6 public finances than the Government actually -8 Forecast enjoys. In practice, the Government can only run a -10 fiscal surplus if another sector of the economy Net borrowing -12 runs a deficit. Indeed, in the OBR s view, one corollary of the public finances returning to the Source : OBR black over the next few years will be the household sector running a persistent deficit, consistent with its forecast of rising household indebtedness. If we are correct that such a rise in household debt is implausible (let alone desirable), the price of the Government achieving its surplus ambition will likely be a slower-growing economy. and its impact on the fiscal stance is unclear The impact of the change of rule on the fiscal plans will not be clear until the Chancellor announces the exact details. If Mr Osborne sticks with the three-year time-span used in the current fiscal mandate, it will mean that the government will need to continue with its plans for aggressive fiscal retrenchment in the short-term. Indeed, the OBR s forecasts suggest that is due to see a greater degree of tightening than any year of the last parliament. On this matter we concur with the OECD, which pointed out in its latest twice-yearly Economic Outlook 4 that failing to even out the planned deficit reduction over the next five years would risk having a damaging impact on growth. However, thus far Mr Osborne has given little indication that he will listen to this advice, particularly in light of the 3bn of in-year cuts to spending in unprotected departments that the Government has announced for the current fiscal year. Justifying those cuts the Chancellor argued that "when it comes to saving money, we all know that the more you can do early, the smoother the ride. 5 3 Speech by the Chancellor of the Exchequer at Mansion House, 10 June United Kingdom - Economic forecast summary, OECD, June Chancellor's speech at the CBI's 2015 annual dinner, 20 May EY 9

11 But given that this profile is already embedded in the fiscal forecasts, if the new framework retains the three-year forecast timeframe then the impact on this Budget is likely to be limited. We have entered a new fiscal year since March s Budget, so the target date for the fiscal rules would roll on to The existing fiscal plans were intended to yield a surplus on the cyclically-adjusted net borrowing measure of 5.4bn in , so even if it were to do nothing the government would already comply with the new, tighter, fiscal rules. However, if the Chancellor defines normal times as being the point at which the output gap is closed, then this could force the government to tighten policy still further. This is because the OBR expects the output gap to be closed in , a year in which it forecasts the cyclically-adjusted net borrowing measure will show a deficit of 11.8bn. Conversely, there is a chance that Mr Osborne could exploit his new framework to ease the pace of fiscal consolidation by restoring the five-year time time-span that was originally applied to the fiscal mandate; such an approach could be justified by the switch to a more stretching target and the need to limit the risk of very aggressive retrenchment damaging growth. That said, stating that the economy will not return to normality until the end of the decade would be very difficult to square with the warm words that Mr Osborne will no doubt express on the economy s performance. It is clear that the choice of timeframe for the new fiscal framework will be the key determinant of any change in the overall fiscal stance over the next five years. Fixing the rollercoaster should be the number one priority The new fiscal framework will also determine the extent to which the Chancellor is able to address the most important issue to be resolved following March s Budget what the OBR termed the departmental spending rollercoaster. The rollercoaster was the unsatisfactory result of coalition disagreement and a number of competing policy aims. The profile for departmental spending sees a severe squeeze in and followed in by the biggest percentage increase for more than a decade. The planned squeeze in the first half of this parliament was partly a function of the Chancellor s decision to reduce the target date for the fiscal mandate from five years to three, although the OBR forecast shows a sizeable structural current budget surplus UK: Departmental current spending % year of 17bn in , rather than the mere balance that the fiscal mandate requires. Meanwhile, the subsequent spending splurge in was the Chancellor s way of neutering Labour s so-called Wigan Pier criticism that the coalition planned to take spending on public services as a share of GDP back to the level of the 1930s. That the impact of these decisions fell largely on departmental spending was a reflection of the fact that the government has limited ability to affect large parts of Annually Managed Expenditure (AME), with spending in areas such as pensions and unemployment benefits is driven mainly by demographics and the state of the economy. And in those AME areas where government decisions could have an impact, largely relating to the generosity of state benefits, the Conservatives were unable to convince the Liberal Democrats to sign up to cutting spending. Thus far the spending totals for and beyond have been largely theoretical, given that the detailed departmental settlements have only been made up until But the government will soon need to present their detailed plans, most likely in a Comprehensive Spending Review in the autumn, and in order for this to happen they will need to present a more coherent profile for total departmental spending as part of the Budget. If the Chancellor does adopt a rolling three-year time-span for the new fiscal rule, current projections for a 5bn surplus on the cyclically-adjusted net borrowing measure in means that there could be some scope to reduce the squeeze on departmental spending by planning for a smaller surplus. Rolling on the target date by an extra year to also means that the very severe cuts for and could spread into that additional year, which is currently due to see sending held flat in real CSR10 CSR13 Unallocated Source : EY ITEM Club calculations using OBR forecasts EY 10

12 terms. But the main hopes for eliminating the worst of the rollercoaster would appear to be twofold. First, following the tradition of the first Budget of a new parliament and raising taxes and, second, by following through with the Conservatives manifesto commitment to place a much greater emphasis on making savings from the welfare bill, thus easing the pressure on departmental spending. In the next section we look at some of these policy options in greater detail. 3. The Chancellor s policy options Any giveaways shouldn t be too much of a surprise Typically, Budget previews are an exercise in soothsaying, seeking to predict what the Chancellor will or won t say in his statement. That exercise is a touch easier this time, given that the Conservatives election manifesto, the (unfunded) pledges made by the Tory high command during the election campaign, the Queen s Speech of 27 May and the Chancellor s Mansion House speech on 10 June all provide good pointers to what measures Mr Osborne will announce, or at least aspire to, on 8 July. Admittedly, the manifesto was drawn up at a time when even the Conservatives themselves likely doubted an outright victory and would have assumed that their more ambitious promises could perhaps be dropped in coalition negotiations. But David Cameron has pledged since the election to implement the manifesto in full. 6 However, the manifesto applies to the parliament as a whole, not just the next few months. And an application of political nous would point to the Chancellor announcing any takeaways as early as possible to get bad news out of the way, while leaving vote-winning giveaways until a Budget or Autumn Statement closer to the next election (or possibly the EU referendum). July s event still offers the potential for Mr Osborne to repeat his habit of springing a Budget surprise note, for example, that none of the big structural changes to the tax and benefit system seen in the last Parliament were included in the 2010 Conservative manifesto. But overall, although freed from the compromises of coalition government, a broadly neutral Budget is likely, emphasising a continuation of steady deficit reduction and with no significant tax rises, but, correspondingly, only a token start to achieving the Conservatives tax-cutting goals. including signalling tax cuts On the latter note, the Budget could see the Chancellor make some baby-steps towards meeting the Conservatives manifesto pledge to increase the personal tax-free allowance from the current 10,600 to 12,500 by This objective is not quite as generous as it sounds. The allowance was already due to rise from 10,600 in to 10,800 in and 11,000 in under the previous coalition s plans. Further rises in line with the OBR s March forecast for inflation would take the amount earned free of income tax to 11,640 by So the Government s pledge amounts in practice to a real-terms increase of 862 in five years time, saving a basic rate taxpayer 172 per year in At the very least, July s Budget will be used as a platform for signalling the Government s commitment to this aim (which would cost around 4bn in today s prices). Were Mr Osborne to begin making some concrete steps in achieving his goal, a boost to next year s relatively meagre 200 rise in the allowance would be an obvious choice. A further 100 rise would cost around 600m. Prospects are complicated slightly by the announcement made in May s Queen s Speech that the Government will legislate to ensure that the tax-free allowance rises at least as fast as the minimum wage. On the basis of past trends, this would mean the allowance increasing, on average, by double the rate of inflation the minimum wage rose by 81% from its introduction in April 1999 to October 2014 but consumer prices increased by 39% over the same period. However, assuming this trend continues and the OBR s inflation forecast proves to be accurate, the Conservative pledge to allow people to earn 12,500 free of tax by the end of the decade should be more than enough to match rises in the minimum wage. 6 David Cameron addresses his Cabinet with pledge to implement Conservative manifesto in full - as it happened, The Telegraph, 12 May EY 11

13 That said, the economic sense of further rises in the tax-free allowance remains questionable to us. Admittedly, as the allowance increases, the Exchequer cost of a given further rise falls. But it also becomes an ever-less effective means of assisting the low-paid. As of 2014, 57% of adults in the UK paid income tax, down from 61% in So more than two-fifths of adults would derive no benefit from a more generous allowance. And since receipt of tax credits is based on after-tax income, tax-credit claimants earning just enough to gain from a higher tax-free allowance would lose around a third of that gain via withdrawal of credits. There also remains a glaring inconsistency between the level of the tax free allowance and that of the primary threshold the point at which employees begin to pay NICs. The latter currently stands at 155 per week or 8,060 per year, with the gap with the tax free allowance steadily widening in recent years. A move to more closely align the two would support those on very low incomes and deliver more bang for the buck in strengthening work incentives, since NICs are only paid on work income. However, this would be an expensive option. The other central tax-cutting plank of the Conservative manifesto was a rise in the 40% higher-rate threshold from the current 42,386 to 50,000 by at an Exchequer cost of 1.9bn in today s prices. Again, this is not quite as much of a giveaway as it first appears. Indexation would imply the allowance reaching 45,490 by the end of the decade, and a further rise to 50,000 would only partly compensate for a long period of below-inflation increases in the allowance in the last Parliament. Indeed, had the higher rate allowance increased with inflation from to , it would already have exceeded 50,000. The 40% allowance is due to rise to 42,700 in and 43,000 in An extra 10% or 420 on the allowance in would cost around 340m. The Budget may also provide signalling or action on other tax giveaways, including Inheritance tax (IHT). The Conservatives pledged in their manifesto to introduce a new 175,000 per person transferable allowance for main residences, meaning that for many couples the total tax-free allowance would rise from the current 750,000 to 1m, at cost to the public purse of around 1bn. The new allowance would be tapered away for those leaving more than 2m, disappearing completely for estates worth 2.7m or more. According to a leaked Treasury document, this new allowance would reduce the proportion of estates liable for IHT from 8% in to just over 6% by the end of the decade, compared to a rise to around 10% under current policy. 7 Productivity efforts are unlikely to deliver anything transformative Mr Osborne is set to reaffirm his desire to see an improvement in UK productivity growth one of the three main tasks he has publicly set himself in this parliament, alongside what he describes as dealing with the UK s debt and raising economic growth outside London in what the Government has termed a plan for productivity, which will probably be published alongside the Budget. The Queen s Speech included some potentially productivity-enhancing measures which the plan may provide more detail on, including an enterprise bill to reduce regulation on small businesses and further moves towards the devolution of power to cities, notably the creation of a Northern Powerhouse. That said, against the huge shortfall in productivity that has built up since 2008, these measures are unlikely to deliver much. A more potent means of boosting the efficiency of the economy would be extra public spending on infrastructure. But this seems unlikely given that the Government already faces squaring the circle of eliminating the budget deficit while meeting its manifesto commitments of tax cuts and extra spending on the NHS and childcare. Meanwhile, other areas of government spending that could potentially be useful in boosting productivity are facing hefty cuts. For example, the Department for Business faces a UK: Output per hour Q = trend = 2.1% y/y Actual Source : EY ITEM Club calculations using data from Haver Analytics 14.5% 7 Budget 2015: Tories 1m inheritance tax break aimed at wealthier households, The Guardian, 17 March EY 12

14 possible 11.5% reduction in its budget over the next three years, hitting spending in areas like R&D and universities. 8 Granted, the squeeze on public spending need not place a barrier in the way of seeking to encourage private sector infrastructure spending with the state providing off-balance sheet loan guarantees. The Budget could also see tax levers pulled to try and stimulate private investment. The extent to which the headline rate of corporation tax has been cut since 2010, from 28% to 20%, suggests that a further reduction is unlikely. But the Chancellor may announce something on the Annual Investment Allowance (AIA). The Conservative manifesto pledged to set a new, significantly higher, permanent level for the Annual Investment Allowance, although no indication was given of what this level would be or when it would be implemented. The AIA currently stands at a temporary 500,000 and is due to fall back to 25,000 next April. Were the current level to be made permanent, it would cost the Exchequer around 2bn per year. Meanwhile, given concerns about the impact of the bank levy on the UK s position as a global financial centre and in light of the drag on productivity growth from a contraction in financial activity since 2008, the Chancellor may choose to replace the bank levy with an alternative tax more favourable to banks with global operations. A corporation tax surcharge levied solely on UK balance sheets has been mooted as possible substitute. 9 Quick decisions around welfare cuts will be needed In terms of giveaways, we think that aspirations rather than action are likely to be the order of the day on 8 July. Aside from the political argument for delaying tax cuts until later in the Parliament, it might be difficult to publicly square any sizable tax reductions now with a still historically-high fiscal deficit and the likelihood that the Chancellor will want to use his Budget statement to emphasise the continued challenge posed by deficit reduction. On that note, Mr Osborne will need to finally put some flesh on the bones of the 12bn cut in welfare spending by that he has been talking about in general terms since the beginning of To date, the Government has set out how it would achieve only a tenth of the 12bn saving, via freezing most working-age benefits in and (cutting the welfare bill by around 1bn per year), as well as modest gains from reducing the annual household benefit cap from 26,000 to 23,000 and from removing the entitlement to housing benefit for some year-olds on jobseeker s allowance (both saving around 100m each). The government could reduce the size of the planned budget surplus, freeing up funds to water down the proposed cut in welfare spending. But having talked about the need for 12bn of reductions for more than a year, it would be politically embarrassing for the Chancellor to take this course. And recent comments by the Prime Minister and the Work and Pensions Secretary point to the cuts going ahead. 10 But the achievement of the 12bn saving won t be easy or painless. Almost half of the cuts to welfare spending in the last Parliament came through indexation policy. But making savings in this manner will be much more difficult in the future given the low rate of inflation expected over the next few years CPI inflation is forecast by the EY ITEM Club to average only 1.1% a year from to compared to 2.8% from Q to Q But the biggest obstacle to achieving the 12bn of savings is the Government s decision to protect most pensioner benefits, which amount to 95bn from a total social security budget of 220bn in Having committed in the election campaign to preserving the triple-lock on state pension uprating and universal pensioner benefits such as winter fuel payments, the Chancellor s scythe will have to fall on the remaining 125bn of benefit spending, which primarily goes to working-age families. A 12bn cut implies taking around 10% off of this budget, or the equivalent of 45 per working age benefit recipient 8 Post-election Austerity: Parties Plans Compared, IFS Briefing Note BN170, Institute for Fiscal Studies. 9 Chancellor poised to axe 3.5bn bank levy, The Times, 10 June Cameron signals assault on tax credits in search for welfare cuts, Financial Times, 21 June EY 13

15 per week. Options under consideration by the Conservatives for contributing to a reduction of this scale were leaked to the BBC in the run-up the election, including regional benefit caps, limiting child benefit to the first two children and taxing disability benefits, so these could appear in Mr Osborne s speech. 11 However, the Government may have boxed itself in on child benefit (forecast to cost 11.3bn in ), with the Prime Minister insisting during the election campaign that the benefit would stay as it is until While this still leaves the option open of freezing child benefit, cuts would be seen as a broken promise. UK: Social security spending in 2015/16 bn Jobseekers' allowance & income support, 5.2 Pension credit, 5.2 Incapacity benefits, 15.1 Disability benefits, 21.6 Housing benefit, 26 Other, 8.7 Tax credits, 29.9 State pensions, 92.1 If child benefit is protected, cuts will have to be focused on the remaining big areas in the welfare budget tax credits, housing benefit, disability benefits and incapacity benefits. Recent speculation has centred on an option suggested by the Institute for Fiscal Studies, namely reducing the child element of universal credit by 30% to its level in real terms, cutting entitlements for about 3.7 million low-income families by about 1,400 a year and saving 5bn. Taxing disability benefits would raise a further 1.5bn. 13 With the total 12bn saving supposed to be achieved by March 2017, rapid action in this or other areas would be needed. This would leave recipients little time to adjust and impact adversely on measured poverty, given the extent to which the UK s current benefit system reduces poverty among households, particularly households lacking people in permanent or full-time employment. 14 Serious cuts to tax credits could also slow employment growth by making low-paid jobs less attractive. These difficulties mean that while reiterating the Government s commitment to reducing the welfare bill, we think that the Chancellor will push back the deadline for the 12bn target beyond , hoping that a combination of economic growth and rising wages will reduce the social security budget in a benign way. Another potential get-out would be to announce reforms to welfare-to-work schemes and scoring the putative savings from this. A cut in the welfare budget formed only one part of the additional fiscal consolidation outlined in very general terms in the Conservative manifesto. 13bn of savings in departmental budgets also featured. The Budget may provide some details on where these savings will arise, and how they can be reconciled with the Tory manifesto pledge to raise NHS spending by an additional 8bn by the end of the parliament, along with the Government s plans for an extension of free child care at a cost of 350m and pre-existing commitments (the removal of the cap on higher education student numbers at a cost of 700m and the 1bn Dilnot social care funding reforms). The Chancellor has already announced 3bn of efficiency savings in selected departments to be made in the current financial year. But the full details of departmental spending plans will probably have to wait until the autumn s Comprehensive Spending Review. as will detail on tax avoidance measures Source : OBR Universal pensioner benefits, 2.8 Child benefit, 11.3 Cuts in public spending are not the only takeaways where the Government will have to add some muchneeded detail. The Conservatives also promised to deliver 5bn of revenues from reducing tax evasion and aggressive tax avoidance. Apart from a proposed increase in the remittance charge paid by nondoms (with the size of the rise unstated so far and likely to generate at best a figure in the low hundreds of millions of pounds), there has been very little information as to where the 5bn will come from, other than vague assertions around further efforts to support global tax co-operation and information sharing. 11 Election 2015: Conservative benefit cut options leaked, 28 March David Cameron: child benefit safe with me for five years, The Telegraph, 2 May George Osborne considering 5bn cuts to child tax credits, 14 OECD (2015), In It Together: Why Less Inequality Benefits All EY 14

16 On the subject of tax rises, the Government has at least been explicit about where the money will come from for the new inheritance tax allowance that the Chancellor may announce in his Budget statement. Prior to the election, the Conservatives said that they would finance this measure by reducing the generosity of pension tax relief for those with an income of above 150,000 per year. At present, pension contributions of up to 40,000 annually can be offset against tax. Under the Conservative s plans, the annual allowance would fall to 10,000 once income reaches 210,000, raising 1.4bn. As far as other tax-raising measures are concerned, we can be confident that there won t be any increase in the headline rates of income tax, VAT or NICs announced in this Budget, or indeed any future fiscal event in this Parliament. The Government s tax-lock commitment, included in the Queen s Speech legislation, will legally bar the Government from raising these tax rates over the course of the next five years. This would compel any revenue generation to focus on other taxes, with fuel duty a potential option, given its position as one of the largest sources of revenue outside the lock categories (receipts of 27bn in ). Press speculation has centred on the Chancellor increasing duty in line with inflation, allowing Mr Osborne to at least claim that the tax was unchanged in real terms. 15 However, with the OBR forecasting that RPI inflation (to which fuel duty is indexed) will run at a low level over the next few years, the sum raised would be very modest. In any case, the OBR s baseline already assumes fuel duty rises in line with inflation after , so an above-inflation rise would be necessary to push up scored revenues. Extra resources could be also extracted from employees by restricting the scope for salary sacrifice where an individual s employment contract is amended to lower their gross salary, but they receive something else in return, which makes them better off. The Government has already ended salary sacrifice in relation to travel and subsistence expenses, and further restrictions could be imposed in the Budget. The Chancellor does have options for removing the worst of the rollercoaster Though completing the deficit reduction plan will be anything but easy, our analysis suggests that the Chancellor does at least have some policy options. While all of these options would still involve further cuts to departmental spending between now and , they would help to remove the worst of the rollercoaster, as the chart to the right demonstrates. There are serious question marks over the achievability of a 12bn cut in welfare spending. But were this saving made, it could potentially reduce the cash terms decline in departmental spending between and from the 9% assumed in the March Budget to 5.2%. If the Government were to also aim for a smaller surplus on the cyclically-adjusted net borrowing measure then the required cuts could be further reduced to 3.8%. Perhaps a more realistic UK: Forecast current receipts in 2015/16 bn ambition would be to achieve 6bn of welfare cuts this would correspond to a cut in departmental spending of 7% over three years Source : OBR UK: Departmental current spending bn Existing fiscal mandate, 12bn of welfare cuts Accelerated surplus, 12bn of welfare cuts Smaller surplus, 12bn of welfare cuts 12bn of welfare cuts 6bn of welfare cuts Budget Source : EY ITEM Club calculations using OBR forecasts 15 Tories fear Osborne will fudge fuel duty promise, The Times, 8 June EY 15