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08 April 2021

Sunak’s Fiscal Headache

With the pandemic in our wake and unprecedented Government spending to support the economy through the crisis, UK debt now stands at previously unimaginable levels. With c.£2.1tn on the books, it is equivalent to 99.4% of GDP and is the highest debt-GDP ratio since 1962. Forecasts suggest that the debt will exceed £2.8tn by 2026, with analysts basing this on a slow and extended economic recovery from the Coronavirus pandemic.
Compared to its peers, the UK has had a successful vaccination programme, but it has not spared many small business and employment. To support businesses and people’s livelihoods, the Chancellor of the Exchequer, Rishi Sunak, has utilised £450bn of quantitative easing to bridge the funding gap. But, with light at the end of the tunnel, Mr Sunak must soon address this burden and will be looking through history at his predecessors’ handling of crises.
A direct approach to reducing the debt is a contractionary fiscal policy. Typically, this includes increasing income and corporate tax rates, increasing the VAT rate on purchases of goods and services and reducing expenditure in general, such as on healthcare infrastructure and military defence, etc. The so-called “Treasury View” – that austerity is the right way to reduce a deficit in adverse economic circumstances – was introduced as a concept in the 1930s. During the Great Depression, the UK Government lowered unemployment benefits to curb the borrowing. For decades, this has been a consistent policy by chancellors, when in the early 1980’s the Government implemented a deflationary fiscal policy which ultimately resulted in a deep recession. More recently, in the wake of the financial crisis, the new Conservative Government pursued a period of austerity to bring down the UK’s debt burden.
The issue today is very different. UK Government debt is around 100% of UK GDP, but the economy is still not in an inflationary or growth stage. For the majority, debt has accumulated to keep the economy afloat, allowing people to maintain a certain standard of living throughout the pandemic. Because the debt has been used for survival and has not fully flowed through into high GDP growth, there are limited inflation concerns. Therefore, the conundrum for the Chancellor remains; using a contractionary fiscal policy could lead to worsening GDP growth and restrict the UK economy from returning to pre-Coronavirus levels, particularly if implemented at such an early stage.
Although this may sound rather contradictory, an expansionary fiscal policy (spending to increase economic activity) can often result in a lower burden of debt. Debt of national governments is rarely paid off. In fact, it is almost always rolled over. Therefore, the issue is not the actual monetary value of the debt, but the key concern is on a country’s ability to service the debt payments (interest cover). At present, the UK Government is adding around £30bn a month to the national debt, three times the rate of a typical month (pre-Coronavirus). Much like a company, it is not optimal for growth when its capital structure has no debt, when there is an opportunity cost in profitable investments. By utilising expansionary fiscal policy such as government spending on infrastructure, healthcare, education/training programmes, the Government should see an economic return on its investment in the future.
The actual quantity of debt is not the issue, but the cost of financing the debt by paying interest payments is the concern. Recently, gilt yields have risen considerably and every 1% increase in this yield results in an additional £20bn of debt interest to be paid. Though, the hope for Mr Sunak is that any inflationary impact will lower the relative cost of repayment in the future. Furthermore, as GDP rises, the ability to service debt increases in tandem with a fall in the debt-GDP ratio. To add to the headache, the UK economy has been damaged by both Brexit and Coronavirus, resulting in concerns over the exportability of company’s goods and services to the EU. Many businesses are now choosing to relocate, despite the UK’s favourable corporate tax levels. More accommodative Corporation Tax could alleviate these capital outflows for the UK, offer more employment, and increase economic growth. However, the announcement last month to raise the headline rate for businesses is the contrary. In a more nuanced approach, Rishi Sunak is providing grants for areas of growth. The £375m future fund to help scale tech start-ups seems well allocated in an area which the UK could excel, given the reputation for high-quality education. Until now it has failed to foster businesses and has lagged behind other developed nations for some time. We are unlikely to see a deflationary fiscal policy, even if the national debt is mounting. By limiting fiscal spending or increasing taxes could result in longer term structural damage and any Government decisions are likely to be accretive to GDP and reduce the burden of debt on a relative basis. Only when the country approaches a comfortable level of GDP growth, and observes meaningful inflation, can the UK employ a more austere strategy as it is used to doing.
This article was taken from the April 2021 issue of the publication, Market Insight. To sign up for our investment publications please visit
Sunak’s Fiscal Headache
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