UK slashes spending, raises VAT and taxes banks

LONDON Tue Jun 22, 2010 1:42pm EDT

Britain's finance minister George Osbourne speaks at the Conservative Party annual conference, in Birmingham, central England on September 29, 2008. REUTERS/Stephen Hird

Britain's finance minister George Osbourne speaks at the Conservative Party annual conference, in Birmingham, central England on September 29, 2008.

Credit: Reuters/Stephen Hird

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LONDON (Reuters) - Britain's coalition government produced the harshest budget in a generation on Tuesday, slashing spending, raising sales tax and slapping a levy on banks to cut a record deficit to almost nothing in five years.

Bond markets rallied and rating agencies gave it a cautious welcome. But analysts questioned whether Conservative finance minister George Osborne's "emergency" budget a month after taking office would plunge Britain back into recession given the scale of the squeeze which lets virtually nobody off the hook.

Japan on Tuesday set ambitious targets to rein in its own debt and Germany has already made plans to pursue savings of 80 billion euros over the next four years, but Washington is concerned about ending stimulus too soon.

Britain's budget will likely strain ties within the coalition -- an unlikely alliance between the center-right Conservatives and the smaller center-left Liberal Democrats formed after an inconclusive May 6 election -- when the really big spending cuts actually start taking effect.

"This is a kill or cure budget," said Andrew Smith, chief economist at KPMG.

"It risks choking off the recovery," he added, echoing U.S. President Barack Obama's warning last week to fellow G20 leaders not to remove stimulus too soon. The G20 summit is in Canada this weekend.

In his statement to parliament, 39-year-old Osborne argued that drastic action was needed given the sovereign debt crisis rippling through the euro zone.

At 11 percent of GDP, Britain's budget deficit rivals that of crisis-hit Greece after the previous Labour government racked up a massive bill bailing out the banks in the credit crisis and paying for the worst recession since World War Two.

Osborne promised to cut that to just 1 percent in five years, a reduction of some 135 billion pounds. The scale of tightening planned is even greater than Canada managed in the 1990s and Ottawa had the benefit of sliding interest rates and a booming export market in the neighboring United States.

VAT sales tax will jump to 20 percent from 17.5 percent in January. Banks will face an annual extra levy of 2 billion pounds, a move in conjunction with Germany and France. Capital gains tax on the sale of assets will rise to 28 percent from the current 18 percent.

Osborne will also go ahead with the previous government's plan to hike a payroll tax known as National Insurance by one percentage point from April despite opposition to it forming a central part of the Conservative election campaign.

To sweeten the pill, however, and appease the LibDems, nearly a million of the lowest income people will be taken out of the income tax net altogether by raising its starting point.

Osborne will also cut the headline rate of corporation tax by one percentage point to 27 percent next year and it will then keep falling though this will come at the expense of other relieves.

COALITION COMPROMISE

More than three-quarters of the fiscal tightening will come from reducing spending. Full details of where the axe will fall will not come until a spending review on October 20 but Osborne said the budget implied cuts of 25 percent over four years for departments outside ring-fenced health and overseas aid.

There will be a two-year pay freeze for public sector workers. Osborne reckoned he could cut 11 billion pounds off the welfare bill. He wants single mothers to go to work when their children go to school, a reduction in the number of people registered as disabled and will impose cap on housing benefits.

Even Britain's royal family will not escape greater scrutiny over its expenditures in the future.

"When we say that we are all in this together, we mean it," Osborne said.

Some economists say heavy fiscal tightening could endanger the recovery and may also be hard to achieve, especially if public sector unions react unfavorably as they probably will.

"It seems to be a tighter budget than people generally were anticipating. By the look of the borrowing numbers, there's a bigger squeeze here than most people were expecting," said Jonathan Loynes, chief UK economist at Capital Economics.

The independent Office for Budget Responsibility, established by Osborne last month, cut its forecast for economic growth to 1.2 percent this year from 1.3 percent published last week. GDP growth next year is seen at 2.3 percent instead of the 2.6 percent published last week.

But many economists say this is probably too optimistic, especially given the scale of the tightening.

The government will be looking to the Bank of England to keep interest rates very low, but some members of the bank's Monetary Policy Committee are wondering how long they can wait before raising rates given inflation remains more than a percentage point above target.

Economists are also worried about deflation.

"The great danger is that the economy turns out to be weaker than anticipated, both because of the budget and for other reasons, causing government borrowing to be correspondingly higher. The budget gives no clue as to how the government might respond," said Roger Bootle, economic advisor to Deloitte.

"This downside economic risk reinforces my view that interest rates are set to remain at or near current levels for the duration of this parliament, and that on inflation the main risk is to the downside. With many countries now competing in the austerity stakes, deflation is a serious risk." (Reporting by Adrian Croft, Keith Weir, Matt Falloon, David Milliken, Christina Fincher, Fiona Shaikh, Peter Griffiths and Avril Ormsby and Kylie Maclennan, editing by Sonya Hepinstall)

($1=.6465 Pound)

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