Osborne Finalizes U.K. Budget

 

U.K. Chancellor George Osborne may be bending under pressure to cut the 50% rate of tax imposed on high earners in next week's budget. Dow Jones's Ainsley Thomson assesses whether he can or should.

Preparations for the U.K. government's budget entered their closing stages Friday, with Chancellor of the Exchequer George Osborne seeking to stimulate the faltering economy while still adhering to his aggressive deficit reduction plan.

During a final round of meetings between Mr. Osborne, Prime Minister David Cameron and their Liberal Democrat colleagues, Deputy Prime Minister Nick Clegg and Chief Secretary to the Treasury Danny Alexander, negotiations are expected to center on finding a compromise between the Lib Dem goal of an income tax break for families and the Conservative Party's wish for a business-friendly budget and a potential cut to the top income-tax rate.

The negotiations are set against the backdrop of sluggish economic growth and come a day after Fitch Ratings became the second ratings agency in the past month to warn that the U.K. may lose its prized triple-A rating if it strays from its deficit reduction plan or if there is an escalation in the euro-zone crisis.

The ratings warning has strengthened Mr. Osborne's resolve to stay the course on the austerity plan and has all but ruled out any chance of an unfunded budget giveaway.

The news isn't all bad for Osborne. Four months ago, when he last updated Britain on the state of the country's finances, he was forced to admit that economic growth would be weaker and borrowing considerably higher than he had hoped.

Next Wednesday, he will have the altogether more pleasant task of saying the U.K. has borrowed less in the 2011/2012 financial year than expected. Economists expect public sector net borrowing for the financial year, which ends on April 5, to undershoot the £127 billion ($199.53 billion) target by between £5 billion and £10 billion. Economists also expect borrowing in the 2012/2013 financial year will be lower than the £120 billion target.

Mr. Osborne is faced with the dilemma of whether he uses this fiscal cushion to fund a stimulus measure, such as a temporary tax cut, or whether he puts it toward reducing the deficit. His rhetoric in recent weeks suggests he is leaning heavily toward the latter.

Philip Rush, economist at Nomura, said he expects the budget to be fiscally neutral, saying the days of "tax, spend, borrow and hope" are long over.

"Delivering a budget that appeases demands from the electorate for the government to 'do something' about the stagnant recovery is no easy feat," Mr. Rush said. "With the public finances still in very poor shape after two years of austerity, the chancellor has to conjure up this something out of virtually nothing."

The chancellor will also be mindful that alongside the budget, the independent Office for Budget Responsibility will state whether he has met his overriding fiscal goals of eliminating the structural deficit over a five-year rolling period and reducing the ratio of net debt to gross domestic product by 2015-16. Economists expect the OBR will judge that he remains on target—just—to meet the goals.

One of the central themes of the budget is expected to be income redistributio—-essentially shifting the burden of the austerity measures to those 'with the broadest shoulders', namely the wealthy.

The Lib Dems, the junior partners in the coalition, have publicly pushed for an income tax break for low-paid workers, saying the pressure on family finances has reached breaking point. The party wants to see an acceleration of the coalition agreement to raise the threshold at which people start paying income tax to £10,000. Lib Dem leader Mr. Clegg has suggested this should be funded by raising taxes on high earners. The chancellor has previously said he is "listening very carefully" to the Lib Dems' proposals.

Mr. Osborne has also come under pressure to do something to help the so-called "squeezed middle"—families who have seen their incomes fall in real terms due to high inflation and muted wage growth. In particular he is being urged to change the controversial policy that will remove child benefits for around 1.2 million families with one adult earning more than £43,000 per year from 2013.

Speculation has been rife in recent days that the current top income-tax rate of 50% on earnings over £150,000 will be lowered. Following claims that the top tax rate was failing to raise significant revenue, Mr. Osborne ordered the tax department to carry out a review, which will be published alongside the budget.

But it is a politically difficult move for the Conservative Party, which has worked hard to change the perception that it is the party of the rich elite. Mr. Osborne will be acutely aware that he will face accusations of pandering to high earners if he removes or reduces the top tax rate without introducing a corresponding tax on wealth.

The Lib Dems have lobbied for the introduction of a 'mansion tax' on properties worth £1 million or more, and last week Mr. Clegg called for a "tycoon tax" that would require wealthy Britons to pay a minimum proportion of their total incomes as tax. Whether or not the two proposals find favor with the Conservative Party remains to be seen, but the two coalition partners could find common ground on clamping down on wealthy people who avoid paying tax.

Both parties want the budget to be as business friendly as possible to try and foster economic growth. There will be a raft of low-cost initiatives included in the budget, such as measures to cut red tape and to improve the competitiveness of the labor market.

Another business friendly initiative expected to be included in the budget is tax relief for British producers of "high-end" television shows like "Downton Abbey". The U.K. government is concerned that Britain is struggling to keep big-budget TV projects in the face of tax competition from abroad. It also sees the export of British entertainment as a way to promote the U.K. overseas.

The Treasury declined to comment on budget speculation.

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