Investment Comment
1st March 2024
Dismal science brightens?
Economics was described as ‘the dismal science’ by Thomas Carlyle in his 1849 essay. And being a fan of Welsh rugby, this year’s Six Nations competition has been one for a dismal scientist to wallow in. Whilst much of economist’s discourse is centred on ‘what’s wrong’ with the world, there is potential evidence of a brightening outlook. Not just because a recession may be avoided but also due to growing evidence that economic growth may be stronger on a secular basis, at least in the US.
US productivity growth accelerated sharply over the course of 2023. Financial markets have been paying close attention to various measures of inflation, wage growth, unemployment and other short-term economic indicators, but productivity might turn out to be the most important economic development and warrants closer attention.
Productivity tells us how much an economy can produce with a given level of resources. Labour productivity, in particular, tells us how much an economy’s workforce can produce given the level of capital stock and technology available. Stronger productivity growth drives faster improvements in incomes and living standards, not just for the overall economy but on a per-head basis. To explain the latter, even if the UK economy hadn’t grown in 2023 (and the most recent data suggests it may have shrunk a little), due to population growth economic activity has fallen on a per head basis. And it’s the per head (or per-capita to give it the economist lingo) that drives living standards and the ‘feel-good’ factor. Albeit this assumes that any economic growth is distributed ‘fairly/equally’ rather than being concentrated into the hands (pockets) of the many and not just the ‘few’.
There are different ways of measuring productivity, and none of them are perfect, but they do tell a story. Overall, the US productivity level remains higher than in other developed economies. In plain speak, that means that the typical worker in the US produces more than the typical worker in other advanced economies. In addition, this gap is growing over time, which wasn’t always the case before the 2008 (parochially it’s good to note that the UK isn’t last on these measures).
US productivity continues to grow more quickly than other economies: Gross Domestic Product per capita growth (measure of productivity)
Source: OECD (2024, Productivity and unit labour costs, OECD Data Explorer accessed 29/02/2024), Artorius
Whilst there is a disconnect between economies and equity markets, those companies with revenue derived from the US have exposure to stronger economic growth than other economies. Some economists would also suggest that US interest rates may settle at a higher level than elsewhere, albeit if productivity growth drives non-inflationary growth (which it should) then interest rates may be driven by other factors.
UK Budget thoughts
With the UK Budget scheduled for Wednesday 6th March, expect lots of paper commentary and leaks in the weekend press. The bare facts are that the UK runs a high fiscal deficit at over £100 billion in 2023-24. This level of borrowing is double the forecast made in March 2022, ironically a forecast made by the then Chancellor Rishi Sunak. So, predictions of falls in future borrowing to justify tax cuts should be taken with blood pressure risk measures of salt.
Tax, as share of national income, is at a multi-decade high and despite this there are signs of strain in public services, as evidenced by NHS waiting lists, school class sizes expanding (even whilst the class rooms themselves are crumbling due to concrete aging) and creaking infrastructure.
Public sector net borrowing forecasts: better than hoped compared to 2023 forecast, but much higher than the 2022 forecast
Total tax revenues as a share of national income: out-turn and official November 2023 forecast
Source: Institute of Fiscal Studies
In speaking to real people (non-economists etc), one area of bafflement is how taxes interact with incomes. Adam Smith (he of the ‘invisible hand’ and championed by free-marketeers) rightly described a good tax system as having certainty (of how the tax due is determined), proportionate on the ability to pay, convenient and efficient in collection.
With the Budget next week, there may be a temptation to reduce the rate of tax for income earners. But what rate of tax, effective or marginal? The effective average rate of tax can be calculated by dividing your take home pay by your gross earnings (i.e. take home pay (after tax) of £38,000, and gross earnings of £50,000 would be an effective tax of 24%).
The marginal rate of tax is more subtle. It is the percentage of tax paid on the next £1 earned. Economists see this as a key measure of incentivisation of whether people choose to work and earn more. The marginal rate of tax in the UK for high earners in theory caps out at 47% (45% income tax and 2% national insurance) once pay has reached £125,140. Dan Neidle (Tax Policy Associates) has produced some stunning work showing how complex UK tax and benefit rules are, and the apparent impact on household incomes. Some readers will be surprised to read that the highest marginal rate of effective tax isn’t 47%.
UK marginal tax rate for single earner (family with 3 children)
UK marginal tax rate for single earner (family with 3 children) including student loan repayments
Source: Tax Policy Associates
When one looks at the actual interaction of taxes and benefits the marginal rate can be much higher than 47%. Child benefits are phased out between £50,000 and £60,000. The bump in the chart above between £50,000 and £60,000 is a 71% marginal tax rate, meaning that, for every additional £1,000 you earn gross, you take home £290.
Looking at it another way: imagine you’re working a reasonably modest 1,500 hours a year (28 hour week) and earning £50,000 gross, so about £38,000 take-home. That’s £33/hour before tax, £25/hour after tax. How would you like to work another 200 hours (about another 3 hours per week) a year for the same hourly rate? Sounds good. But after-tax you’ll actually be earning £9.57/hour. And, given that £9.57 is less than the minimum wage, if you need childcare cover then that could easily cost you more than the additional pay.
The personal allowance is phased out between £100,000 and £125,140. The bump between £100,000 and £125,000 is the withdrawal of the personal allowance, and results in a 62% marginal rate between £100,000 and £125,000. Not quite as dramatic as the 71%, but still well over the psychologically important 50% mark – and that rate lasts for a significant £25,000.
And then comes the impact of student loans, which are really just a complicated hidden graduate tax. Graduates over the past 20 years are seeing a marginal rate tax on their incomes up to 70%. For someone starting university before 2012, you pay 9% of your salary over £20,184, until the loan is repaid. Of course, the effect on individuals – even those on the same income – will vary widely, depending on how much they borrowed, how long they’ve been earning, and how their salary ramped up over time. The broad effect is just to raise all the marginal rates by 9%. Graduates with children can therefore easily suffer from marginal rates of 80%. Do we as a country want to disincentivise university attendance or families?
A call for simplicity and fairness may be too much to hope for, but the complexity of the tax system is having an effect. Similar to that which saw doctors reduce hours so as not to trigger pension penalties, the real pocket impact of policies matter. So, whilst budget headlines may be written around non-dom taxation, inheritance tax and the marginal rate of taxes, the actual tax rates felt by individuals are not marginal or seemingly rational.
And given that it’s 1st March, Dydd Gŵyl Dewi Hapus.
Gerard Lane Chief Investment Officer
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