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UK: Truss Government Faces Immediate Fiscal Credibility Challenge Amid Tax, Spending Promises

By:
Eiko Sievert
Published: Sep 5, 2022, 19:08 UTC

New UK Prime Minister Liz Truss’s tax-cutting and spending plans risk straining public finances and investor confidence if reforms do not enhance fiscal credibility and economic governance.

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Elected Monday as leader of the ruling Conservative Party, so becoming the United Kingdom (rated 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 skyrocket, and the pound weakening sharply against the US dollar, success in helping households 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.

Specific Challenge for Truss Government of Large Stock of Inflation-linked Bonds

One challenge specific to the UK that 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 for 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 crisis 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 a Wide Range of Policy Changes, Such as Tax Reform

Truss promises a wide range of policy changes, including significant spending commitments, tax reform and re-assessments of the nation’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 debt burden and is symptomatic of shortcomings of the UK fiscal framework. Unlike the more rigid frameworks of Germany or several Nordic countries, the UK framework has been frequently adapted over recent years as a response to the economic outlook.

Proposed tax reforms would likely aim to at least contain the tax burden. According to previous estimates of the Office for Budget Responsibility, this was on course to reach its highest levels since the 1960s over the next few years, particularly due to planned rises in corporation tax rates.

Changes to lower the tax burden are likely to include a reversal of an April rise in national insurance contributions, scrapping planned corporation tax rises, and reviewing business rates, taxes on the self-employed and inheritance taxes.

However, this could lead to lower tax intake over the coming years if the cuts do not provide sufficient impetus for economic activity to offset 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.

Concerns Prevail Over Robustness of Financial Supervisory, Economic and Monetary Governance Frameworks

To the uncertainty on the outlook for public finances there are concerns around the future of the country’s presently robust financial supervisory, economic and monetary governance frameworks that 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 sovereign’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 prove crucial.

For a look at all of today’s economic events, check out our economic calendar.

Eiko Sievert is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

About the Author

Eiko Sievertcontributor

Eiko Sievert is a Director in Scope’s Sovereign & Public Sector ratings group, responsible for ratings and research on a number of sovereign and supranational borrowers.

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