Why Europe Should Avoid Fiscal Largesse

Although the next UK budget is not due for several months, there are already growing calls for the government to cancel the planned increase in corporation tax. The decline in energy prices has reduced the expected outflows for the UK's energy price guarantee scheme (EPG). Furthermore, a far stronger fiscal outlook has been confirmed by the surprise budget surplus registered in January, which was boosted by income tax receipts. This trend is not unique to the UK, as better-than-expected growth, higher earnings, and lower energy prices have already resulted in improved survey data for the private sector and better tax receipts across Europe.

While this will provide governments with greater flexibility should additional fiscal support be required, it could also pose a challenge for central banks struggling to control demand. The last thing they need is fiscal largesse, particularly in the form of subsidies or other measures that could offset monetary restraint. This is a new risk that could prolong the tightening cycle in Europe. Nonetheless, the general improvement in growth would be a welcome development in any case.

The last thing central banks likely need at this point is fiscal largesse. At present, the primary concern for unexpected fiscal loosening is likely to be in the UK. The breakdown of key tax revenue components for the UK Treasury is shown in the chart below. Typically, Self-Assessment (SA) filings lead to a significant increase in tax payments by the end of January from individuals and entities deemed to have underpaid taxes. This year's SA contribution is exceptionally high, while other components remain strong.

There are concerns regarding income distribution in the UK, as those who pay taxes under self-assessment often have a higher income threshold (£100,000 according to the government) in addition to the conventional Pay-As-You-Earn (PAYE) framework. Additionally, earnings inflation without corresponding increases in tax thresholds, also known as a 'stealth-tax,' has contributed to this trend. Despite accounting for these factors and recognizing that government outlays are subject to similar inflation pressures, the surplus still reflects strong income growth. This is particularly notable given that the Bank of England and Office for Budget Responsibility (OBR) had projected a two-year decline in real income as the original scenario, which formed the basis for the government's fiscal discipline.

In reality, the tight labour market has supported wages, while household energy outlays may not be as severe as initially anticipated. Nonetheless, the surplus raises questions about the UK's fiscal policy going forward.

UK Tax Receipts, Key Components:

The January 2023 UK corporate tax intake is comfortably positive in real terms after adjusting for inflation

A comparable trend is emerging in Europe, particularly in Germany. As shown in the chart below, German monthly revenue components indicate that taxes on earnings (both assessed and non-assessed) were robust for Q4 2022, while the corporation tax intake also reached a record high. The UK experienced a similar phenomenon, with January being the strongest month for corporate tax. The £22bn intake for 2023 is 33% higher than the previous record in 2021, and is comfortably positive in real terms after adjusting for inflation. Windfall taxes and long-standing surcharges on record energy profits have played a role in this trend, leading to calls for a freeze in corporation tax rates.

These developments raise questions about whether the government will opt to increase spending or cut taxes in response to the surplus. It is possible that the improved fiscal outlook could lead to greater flexibility in terms of fiscal support, but central banks may be hesitant to allow for fiscal largesse, as this could lead to a prolonged tightening cycle. Nonetheless, the positive growth trends are a welcome development in Europe, and it will be interesting to see how governments respond to the changing fiscal landscape.

German Tax Receipts, Key Components

Direct or indirect fiscal injection out of political expedience or necessity now represents a clear upside risk to terminal rates

There are also indications of strong household demand and income levels based on Value-Added Tax (VAT) receipts in key Eurozone economies, which incorporate changes in services consumption. The chart below shows de-trended VAT receipts in Germany and the UK since 2010, and even accounting for seasonality, the surge in the UK towards the end of 2022 has been exceptional. While the lift in Germany has not been as strong, it is still noteworthy. It is possible that the uncertainty across the continent and in the UK through mid-2022 depressed demand for different reasons, but households sharply curtailed demand in anticipation of a heavily-flagged cost-of-living crisis. This period represented the apex in energy prices, and household expenditure on non-fuel or energy items likely fell in anticipation of a sharp rise in utilities and transport costs.

However, recent trends in baseload prices have shown that European economies have fully adjusted and, for now, appear well-prepared for next winter. This not only reduces the need for new energy subsidies by governments, but also increases revenue through consumption increases. For the time being, this trend is contributing to positive growth trends and improved fiscal outlooks in Europe, and it will be interesting to see how this plays out in the coming months.

VAT Receipts, UK And Germany (de-trended)

Reducing corporate taxes could pose political challenges for all governments, as it's unlikely that the resulting earnings would be passed on to consumers. While such a move could increase margins and spur investment in regional equities, central banks are currently cautious about the economic outlook. Higher wages have a more lasting effect on household expectations than changes in taxation, so we anticipate central banks quietly supporting government efforts to maintain fiscal restraint. As the chart below demonstrates, the UK and Germany are expected to undergo significant fiscal retrenchment this year and in the long term, while the US is in a completely different fiscal position.

Change In Debt-to-GDP Ratio

The global growth trajectory and monetary policy divergence are likely to be impacted by government demand and spending. Central banks, particularly in the US, are at a point in the economic cycle where they want to avoid sudden upside surprises to their terminal outlook. Any unexpected fiscal loosening could create significant currency shifts in the near future. While current European governments hope to keep fiscal paths in place, there is a recurring theme of industrial action, particularly in the UK. Therefore, anchoring wages remains crucial to the policy outlook. Direct or indirect fiscal injection out of political expedience or necessity now represents a clear upside risk to terminal rates.

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