Will a Surprise Reduction in UK Government Borrowing Open the Door for Tax Cuts?

Spotlight: The Power of Compound Returns

Imagine a world where we could make our money work just that little bit harder. This is made possible by the mathematical phenomenon of compounding, a financial snowball effect where you can effectively earn a return not just on your initial investment, but also on all the subsequent returns generated.
 
So how does one take advantage of compounding when it comes to investing? One perhaps underappreciated option is to start earlier – as if one was to roll the snowball from a higher point on the hill. By starting your investment journey earlier, any gains made in these earlier years can have a significant impact on the ultimate value of your investments (the snowball grows at an increasing rate). Limiting the amount of withdrawals and staying invested can also help to maximise the effects of compounding, with the potential to accumulate a greater pot when it comes to retirement.
 
Investing in growth assets such as equities have historically shown to be powerful compounders of wealth, driven by the twin forces of capital appreciation and the reinvestment of dividends. Every time your equity portfolio receives a dividend, this can immediately be put to work by investing in more shares, and so on and so forth. Better still, if one can find companies that are themselves growing their profits and paying increasing dividends to their investors over time, we can benefit further. This makes equities somewhat unique as an asset class – it is much harder to reinvest your monthly rent in another property (and you may even be paying interest on a mortgage rather than receiving it!).
 
It is worth noting that the principles of compound interest are best aligned with a long-term investment strategy. Of course in the real world, investment returns fluctuate and are not guaranteed, investments don’t rise in a straight line and are subject to volatility. Unforeseen events may force an investor to access their savings earlier than planned and additional factors also need to be considered, such as the costs of investing, or inflation reducing the spending power of returns. The following simple example sets these issues aside to illustrate the long-term benefits of compounding.

Let us consider the example of rolling the snowball down the hill from a higher point.  Assuming an initial investment of £1,000, a yearly addition of £1,000, an 8% annual return and no withdrawals, the investor starting at age 20 will generate over twice as much from their investment than the investor starting at age 30.
 
The chart below highlights the difference in return from having started 10 years earlier and only contributed £10,000 more to achieve an almost £250,000 bigger return. As depicted in the chart, a longer-term strategy maximises the potential for longer term gains from compounding. Note that in both cases that the lines are becoming steeper over time as the portfolio grows at an increasing rate – this is due to the phenomenon that is compounding.

The Noise

• The US economy grew faster than anticipated in the fourth quarter of 2023, as strong consumer spending and moderately improved business investment fought off pressure imposed by high interest rates. It expanded at an annualised rate of 3.3%, much better than economist forecasts of 2%. Many economists have now rescinded their recession expectations and expect economic expansion to continue through 2024, though at a slower pace. Following the data release, financial markets have reduced their expectation of a March interest rate cut to below 50%, though the odds have risen for a cut at the Federal Reserve’s May policy meeting. Equities on Wall Street also trended higher, with the US dollar gaining value against a basket of currencies, US Treasury yields fell.

• The European Central Bank (ECB) maintained its record-high 4% interest rate this week, and reiterated its commitment to combating inflation, even as the time to consider easing borrowing costs approaches. The ECB ended its fastest-ever rate hike cycle in September last year, yet it has remained resolute in its belief that it is still too soon to start discussing a reduction in its policy rate. ECB president Christine Lagarde shared the Committee’s belief that they “still need to be further along the disinflation process to be confident that inflation will be at target – sustainably so”. Policymakers speaking after the meeting expressed openness to a change in rhetoric at their next meeting in March. This could open the door for an interest rate cut in June, should upcoming data confirm inflation has been contained. Market sentiment suggests that investors believe the ECB is getting it wrong on both inflation and growth, they anticipate a reversal in policy that will result in five rate cuts in quick succession from early spring.

• A group of investors managing more than $25 trillion have said they plan to challenge mining companies that are yet to commit to a tailings dam best-practice standard. Tailings dams are embankments constructed near mines to store waste, and depending on the type of mining the waste can be solid, liquid, or a mixture of both. The Investor Mining and Tailings Safety Initiative currently has 77 member firms, with the investor group indicating that they may start voting against management at the upcoming annual meetings for the 126 firms that are yet to commit to best practice. More than 14,000 active and legacy tailing dam facilities across 77 countries have been identified, with the structural failure of any dams having detrimental environmental and social impacts. This week, a Brazilian federal judge ruled that mining companies Vale and BHP must pay $9.67 billion in damages for a 2015 tailings dam failure that killed 19 people and severely polluted the Rio Doce River.

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The Numbers

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The Nuance

UK government borrowing, the difference between its spending and income from taxes, fell to £7.8 billion in December per the Office for National Statistics. This is much lower than the £14 billion in borrowing expected by Economists, and £8.4 billion less than a year ago, marking the lowest December borrowing since 2019. The UK government’s interest payments are linked to the Retail Prices Index measure of inflation. So, a bigger than anticipated fall in inflation resulted in smaller interest payments in December than predicted, which has contributed to better-than-expected borrowing data.

This positive surprise is a boost for Chancellor of the Exchequer Jeremy Hunt, as it could give him more wiggle room to incorporate tax cuts into his March budget. As recently as last week at the World Economic Forum in Davos he had hinted at wanting to cut taxes ahead of a general election expected later this year. Britain is currently on track to have the highest tax burden, as measured by taxes as a proportion of gross domestic product, since the Second World War, which has been a key point of contention for many lawmakers in the ruling Tory party.

The Institute for Fiscal Studies (IFS), a leading independent UK think tank has warned against tax cuts. They have pushed back that the UK economy is facing some of its biggest issues since the 1950s, and that any tax cut will either need to be reversed or spending cuts will need to be made. 

 

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