Reflections in a time of Covid

A year on

Last Thursday marked the first anniversary of the World Health Organisation's classification of the Covid-19 outbreak as a pandemic. The lives of millions of people have since been put on hold as governments have been forced to lock down their economies in a bid to halt the spread of the disease. There have recently been some signs of improvement with the mortality rate across Europe significantly below its January peak as a result of renewed lockdown conditions and the acceleration of the vaccine rollout. However, daily case numbers are rising again in a number of continental European countries. They have almost doubled in Italy in the past three weeks, prompting the government to tighten restrictions, whilst in Germany the Robert Koch Institute for infectious diseases predicted that the number of daily reported cases could exceed the December peak by mid-April. The rate of decline in UK cases, which has been proceeding rapidly for the past two months, has recently slowed although there is insufficient evidence to know whether this marks a turnaround or is just a blip.

We have learned a lot about pandemics and how to manage them over the past year. The most important lesson is that lockdowns do work and in this regard the UK was slow off the mark in spring 2020. It is sobering to recollect that health experts were aware of the scale of the problem ahead of us. This edition of Question Time, the BBC’s weekly topical debate programme, from 12 March 2020 featured Professor John Ashton who delivered a withering critique of government policy and accurately predicted what was about to unfold. His efforts to highlight the extent of the disaster stood in stark contrast to the complacency of government ministers at the time. The fact that more than 125,000 people in Britain have died from Covid over the last year – the fifth highest total in the world – is testimony to policy failings. When normalised to account for the size of population, the UK’s mortality rate of 188 per 100,000 is the highest of any country with a population over 12 million (chart 1).

The more positive news is that the vaccination rollout appears to be a great success. Although Israel is well out front in terms of vaccinations delivered, the UK and US are gaining momentum (chart 2). It is sobering to recall that a year ago we were warned that it could take years for an effective vaccine to be developed. At that time the fastest any vaccine had previously been developed, from viral sampling to approval, was four years – for mumps in the 1960s. The vaccination process has not been without its controversies: Concerns persist about the effectiveness of the AstraZeneca vaccine with the most recent issues surrounding its potential side effects. In addition, there is a vaccine hoarding problem with the developed nations having bought a large supply of the world’s available stock, thereby leaving less for the poorer nations. Nonetheless, it is remarkable that such huge strides have been made in the space of just 12 months.

But we are not yet out of the woods. Lockdowns in some form or another are likely to remain in place well into April, which effectively means that economies in most parts of Europe will be operating under highly restricted conditions for up to one-third of the year. So long as concerns about new Covid variants remain a live issue, we cannot afford to be complacent with regard to the prospect of a further coronavirus wave.

Counting the economic cost

From an economic and market perspective it has been a wild ride. Last year saw the largest peacetime contractions in output in almost a century (more than 300 years in the UK case) and we cannot be confident about the pace of the rebound in 2021. In spring 2020 it was widely assumed that the contraction would be followed by a rapid recovery but a second wave of the pandemic has led to rather more muted hopes across Europe. That said, the OECD recently revised up its expectations for global growth in 2021 compared with last November with particularly rapid growth projected for China (7.8%) and the US (6.5%). Latest UK figures give some grounds for optimism, with GDP in January falling by only 2.9% versus expectations of something closer to 5%, and as a consequence it is likely that Q1 growth will turn out less bad than the 3.5% contraction currently pencilled in by the consensus (which will raise the annual growth rate, ceteris paribus).

The jury is still out as to the nature of the economic recovery. The economic shock has had implications for both the supply and demand side and the shape of the recovery will be determined by trends on both sides. Demand is likely to rebound fairly quickly, particularly given the extent of unanticipated household saving which is likely to be rapidly run down (chart 3). That said whilst spending on goods may pick up as the retail sector opens up, a lot of the spending on services which has not taken place over the last year will simply not be recouped. After all, we are unlikely to go on more holidays or make up for a year’s worth of foregone restaurant meals. It is for this reason that the damage to the supply side of the economy is hard to gauge. The future states of the airline and retail sectors are likely to be different to their pre-Covid form, whilst the leisure sector has taken a battering from which many establishments will find it difficult to recover. It is for this reason that I maintain the recovery may prove slower than a lot of projections currently suggest. 

Markets on edge

From a market perspective, in March 2020 we were about to step into the unknown – never in living memory had we experienced a global pandemic and equity markets quite simply collapsed in the face of unprecedented uncertainty. Following the actions of central banks to provide unlimited liquidity, the subsequent rebound took many by surprise – myself included. Indeed, we are now at the point where many investors believe the equity rally is overdone with the S&P500 closing last week at a record high – around 17% above the pre-pandemic high in February 2020, despite the economic collapse, and 76% above the low a year ago. This has occurred at the same time as fixed income markets have sold off as inflation concerns mount in the wake of the huge US stimulus package – a fiscal strategy which might have been better served had it been introduced last year.

It remains to be seen whether inflation fears will be realised. However, if inflation does pick up the fiscal stimulus is unlikely to be the only catalyst. Equally important – if not more so – are events in China where demographics mean that it will be increasingly difficult in future to generate big increases in output by increasing the labour contribution. To the extent that the quiescence of inflation over the last twenty years has had more to do with the expansion of low-cost global production capacity in emerging markets than anything that has happened in the industrialised world, events in China will be the key to markets in the years ahead.

One of the potential side effects of the Covid crisis is that it may serve to mask a number of secular trends that we initially ascribe to the events of the past year but are in reality due to other factors. This was the case following the bursting of the Japanese bubble economy in 1990 and the GFC of 2008-09 when a slowdown in population growth resulted in slower potential growth in the wake of the crisis, giving rise to a much slower recovery than anticipated. As we reflect on an unprecedented year, we have learned a lot about pandemics and how to combat them but we have a lot still to learn about the long-term effects on the economy and markets. There is a long way to go before we can contemplate a return to economic normality, and whatever the new normal is, I suspect it will not be like the old one.

Corporate health risks

Whilst the presentation of the government’s financial plans in many countries is often a dry affair focused on the impact of the fiscal measures on public finances, it is increasingly used as a showpiece political event in the UK as the government tries to put the rosiest possible spin on tax and spending measures. Not only does the UK budget generate a lot of commentary and analysis ahead of the event, but the sheer volume of the material released on Budget Day means that it often pays to avoid instant commentary as the full implications of the measures percolate through. The Office for Budget Responsibility’s Economic and Fiscal Outlook alone represented 222 pages of detailed analysis of the UK’s economic situation, covering everything you might want to know (and a lot that you don’t), and there is a lot more besides.

By general consent, Wednesday’s budget was a “spend now, tax later” affair in which the government plans to continue providing a significant amount of economic support in the near-term but intends to pursue a more aggressive fiscal tightening beyond 2023. Indeed, the fiscal expansion measures over the next two years are offset by a planned fiscal tightening over the following three years and by 2026 the ratio of tax revenue to GDP is projected to reach its highest since the late-1960s (chart 1). The fact that the majority of the fiscal tightening falls on tax increases rather than spending cuts is a recognition that it will be politically difficult to repeat the austerity measures that were implemented in the wake of the 2009-09 recession. Indeed, I have been pointing out for some years that planned cuts in corporate taxes were putting an unnecessary strain on the budget deficit.

The impact of raising corporate tax rates

The primary tax measure announced in the budget was a rise in corporate taxes from the current rate of 19% to 25% in 2023 which would leave it in the middle of the range of a group of 37 countries, rather than significantly below (chart 2). This flies in the face of the low tax orthodoxy espoused by successive Conservative governments over the past 40 years and represents the first increase since 1974, when it was raised from an already-high rate of 40% to an eye-watering 52%. This week’s announcement was driven by two factors. First, in its 2019 manifesto the Conservative party committed to not raising income tax, national insurance or VAT rates, leaving it with few alternatives. Second, there has been growing disquiet in recent years that efforts to slash corporate taxes meant that many companies were getting off lightly at a time when individuals were bearing the costs of austerity.

The OBR highlighted that although the tax rate has been slashed sharply over the years, the share of corporate tax receipts in GDP has fluctuated in a narrow range centred around 3%. This reflects the fact that the tax base has been widened over time, thus offsetting the revenue-dampening effects. In theory, applying higher tax rates to a wider base ought to significantly increase revenue. One concession applied to the latest package is that companies generating less than £50k per annum in profits will continue to pay a tax rate of 19% with a graduated scale applicable on profits above this limit, to a maximum of 25%. The government reckons that 70% of companies will continue to pay a rate of 19%. The fact that the remaining 30% will contribute an extra £20bn in taxes by 2026 compared to estimates made in November (an increase of 31%) suggests that larger companies will be hit hard. Fears expressed in EU circles that the UK would embark on a regime of tax competition to undercut companies in continental Europe appear to be unfounded.

But tax increases have consequences. In the first instance, companies that may be considering whether they need to continue operations in the UK after Brexit may use higher taxes as a reason to move elsewhere. In addition, curbs on corporate profitability may have adverse effects on job creation in the medium-term. Moreover, expectations of reduced future profitability will depress the capacity to pay out dividends, fund buybacks and pay down debt, not to mention reducing the net present value of corporate earnings. All of these factors might be expected to depress UK equity valuations relative to other markets. Raising taxes will, other things being equal, also reduce the capacity to fund capital investment.

Pros and cons of generous investment allowances

In order to offset the worst of the investment problem, the government unveiled a generous two-year temporary capital allowance covering the fiscal years 2021-22 and 2022-23, in which companies will be able to offset 130% of investment spending on eligible plant and machinery against profits. The evidence does suggest that such measures have a stimulatory impact on investment since they reduce the user cost of capital (the tax-adjusted marginal cost of capital). Moreover, tax incentives tend to have a bigger impact on long-lasting assets. At a time when the UK is keen to encourage the switch away from combustion-engine vehicles, which will require significant investment in the infrastructure to support the adoption of battery-powered vehicles, the tax breaks could give this particular project a big shot in the arm.

However, temporary tax breaks suffice only to shift the timing of investment projects rather than leading to a permanent increase. The OBR’s forecast indeed suggests that a big investment surge in 2022 will be followed by only a moderate increase thereafter. Between 2007 and 2016, business fixed investment increased at a paltry annual rate averaging just 1.6%. Between 2016 and 2019, in the wake of the Brexit referendum, it barely increased at all and despite the budget measures introduced last week the OBR’s projections point to growth of just 0.8% per annum between 2016 and 2025 (chart 3).

Moreover, there are particularly high levels of uncertainty at present which run the risk that efforts to stimulate investment may not have the desired effect. Incentive measures presuppose that there is a lot of investment waiting to be brought online. As MPC member Jonathan Haskel noted in a speech yesterday, “residual uncertainty and risk aversion over the recovery are likely to continue to weigh on investment,” particularly in the wake of Brexit. There is also a lot of spare capacity in the economy at present – my own estimates suggest that the output gap this year is likely to average -2.6%, narrowing to -0.7% in 2022. In addition, the tax incentives are only useful if companies generate a profit. In the post-pandemic recovery phase profitability may remain under pressure, although to mitigate this effect the government has extended the loss carry back rules which allow companies to offset past trading losses against profits.

Whilst efforts to boost investment are welcome, one of the drawbacks associated with the tax allowance is that it is aimed squarely at tangible assets but there is no incentive for investment in intangibles which is a problem in an increasingly digital economy. This may continue to act as a drag on multifactor productivity, which in the past decade has posted its slowest growth in a century, which will in turn hold back potential GDP growth. 

Last word

When asked last year whether I expected the Chancellor to announce fiscal consolidation measures in 2021, my response was “it is likely that some form of fiscal consolidation will be announced in 2021 though may not necessarily be immediately implemented.” This expectation has been borne out. It was inevitable that corporates would be asked to shoulder a bigger part of the fiscal repair bill and the government has tried to sweeten the pill by offering generous investment allowances. But the strategy does represent a risk to the health of UK PLC. Like many aspects of budgetary policy, however, we will only know the outcome many years from now.

Time to rethink the tax system

Looking to next week …

Next week the Chancellor will present the annual UK budget in which he must strike a balance between providing support to the economy in these unprecedented times whilst suggesting that measures will need to be put in place to plug the fiscal gap. Unlike in times past when the purdah period ahead of the budget meant there was complete radio silence on the expected measures, this year the plans have been splashed all over the weekend newspapers. They highlight that the government is planning a “restart” grant scheme to provide funds to allow businesses to reopen after the Covid lockdown and an extension of the furlough scheme through June. In addition, the government is expected to announce measures to support house buying, including a time-limited extension to the stamp duty holiday and help for people hoping to get on the property ladder.

Any message that the government is trying to convey via the media should be taken with a huge pinch of salt. Whilst it is giving the impression that it remains committed to providing support, a £5bn restart fund is chickenfeed in fiscal terms (0.2% of GDP) – as one below-the-line contributor to the FT story sardonically commented, “why not just send a card?” I have noted on previous occasions that the media representation of fiscal aggregates is akin to a form of money illusion if measures are simply reported in absolute terms without giving any form of context. A £5bn fund sounds big to the average punter but it will only deliver a payout of up to £18,000 for the biggest firms. Small businesses will obviously get less and the payout may not even cover the fixed costs of running a business during the lockdown. This is not to say that support is unwelcome but it highlights that the state’s generosity is more limited than ministers would have us believe. Nor is it clear that measures to further inflate the housing market will do much to tackle the UK’s economic woes. Inflating the price of non-productive assets may make voters feel good but it is of questionable economic benefit.

Naturally politicians want to deliver only good news whilst hiding the bad and there has been less discussion of any fiscal tightening measures. However, Chancellor Sunak has promised to “level with people” over the “enormous strains” in Britain’s public finances and warns that the bill will fall due at some point. Matters have been made more complicated by the foolish commitment in the 2019 election manifesto to rule out increases in income tax, national insurance and VAT rates though whether that is adhered to in the long run remains to be seen. One of the measures likely next week is a freeze in income tax thresholds which will push people into higher tax bands as their income rises, although the fiscal effect of this will be limited, yielding less than £1bn in FY 2022-23. There has been some chatter about whether corporate taxes will rise. Whilst this may be postponed to the future as there are genuine questions as to whether this is the right time to be talking about fiscal tightening, it is a measure likely to come onto the agenda sooner or later.

… And beyond

Much of the discussion around fiscal tightening centres around tinkering with existing taxes. But looking ahead, now would be as good a time as any to open up a discussion about the future shape of the tax system. After all the current system largely grew out of a twentieth century economy but given the impact of the pandemic on the structure of the economy and the need to reshape fiscal policy in its wake, it would now seem to be a good time to announce a long-term public consultation on the scope of tax reform. This would build on the excellent body of work conducted by the Mirrlees Review in 2010 and 2011 which was motivated by the fact that the tax system has grown in an ad hoc way and “remains the product of often incoherent piecemeal changes rather than strategic design.”

Although the British system is fairly efficient in an international context, offering relatively few loopholes and opportunities for avoidance, and is on the whole non-intrusive, it is far from perfect. We can broadly categorise measures into easy fixes and ones which require a much deeper level of consideration. In terms of the former category, I repeat my call for a reduction in the benefits taper rate (the rate at which in-work benefits are withdrawn as people take on paid employment) which would eliminate the burden on some of the least well-off in society whilst also increasing their work incentives.

Other relatively easy fixes include increasing capital gains tax to align it with income taxes, as recommended by the Office of Tax Simplification, to ensure equal tax treatment of labour income and wealth income. Another fix would be to limit the rate of pension tax relief to 20%, thus reducing the regressive treatment of pension contributions which currently favour higher rate taxpayers, whilst abolishing the double taxation of interest income would be a welcome vote winner. Finally in terms of easy fixes, there is a case for abolishing the distinction between national insurance contributions (NICs) and income taxes as a way of simplifying the tax system. In fairness this was considered in the 1980s but the then-Chancellor concluded that “the benefits of a combined charge would be unlikely to justify the ensuing upheaval.”

There are a number of more complex questions to be asked of the tax system which require a lot more thought. To the extent that income tax, VAT and national insurance contributions together account for around 60% of revenues there is a case for thinking about ways to widen the tax base. One option would be to consider the possibility of a wealth tax. I did look at this issue three years ago and concluded that there are many practical objections which means it may be more trouble than it is worth. But there are some attractive features, especially in the wake of the pandemic in which young asset-poor people have been forced to make sacrifices to shield older asset-rich people.

Another area ripe for reform is corporate taxation. The standard belief is that there is a case for raising the tax rate which is relatively low in an international context. There is some merit to this but there is a lot more to the issue than simply tax rates. For example, a recent OECD symposium looked at ways to levy tax based on the location of customers rather than legal domicile and there is a big debate around the taxation of digital services which is very much in its infancy. A related issue in the corporate taxation debate is the extent to which debt finance receives more favourable treatment than equity finance. By allowing the tax deductibility of debt interest payments against profits, the base against which corporate taxes are levied is artificially reduced.There is scope to look more closely at this anomaly.

Last word

There are numerous other areas ripe for reform (local authority financing being one of them and I will come back to that another time). As Stuart Adam and Helen Miller noted in a recent IFS report “The parts of the UK tax system that dictate how different forms of income are taxed are of central importance and are not fit for purpose … The tax treatment of returns to investment is a mess … And this is just the start; the list of problems is long.” These are very strong arguments in favour of rethinking the tax system to make it more applicable to the economy of the 21^st century. Just as we need a debate about what we want the state to provide following the pandemic, we need a debate about how to pay for it.