The coalition Government has announced more than £6bn of spending cuts to chip away at Britain's £163bn fiscal deficit, the highest in the EU. How will these austerity measures affect consumer spending? William Grobel from Intangible Business, reports.

The UK owes £163bn, 12% of GDP and this is forecast to rise to over £180bn by the end of the year. This is the highest in the whole of Europe, surpassing that of even Greece which has had to be bailed out by the EU and IMF. This position is clearly unsustainable and is a top priority for the Cameron, Clegg coalition. The tactics the new government implements to reduce this deficit and attempt to resuscitate the economy are inevitably going to impact the spending power of the UK consumer.

The dual strategy of fiscal tightening and higher taxation is the unavoidable solution. As a reduced demand could hinder economy recovery, a precarious balancing act will be necessary. This article will look at the key measures which are indicative of forthcoming austerity to try and establish what this means for consumer spending and how this will effect corporate UK.

VAT increases
Although both Conservatives and Liberal Democrats remained relatively noncommittal to a VAT rise during the election, a VAT increase is likely to be the first measure to be introduced as it can be implemented immediately and has an immediate effect, as witnessed by the reduction to 15% implemented in 2008.

The UK’s current VAT rate of 17.5% is below that of many European countries; Germany on 19%, France on 19.6% and Sweden on 25%. A rise to 20% in the UK would be the most likely outcome. According to research conducted by the Centre for Retail Research for Kelkoo, a VAT increase to 20% would generate an additional £11.4bn of tax earnings for the Treasury. This equates to a cost of £425 for each of the UK’s 26 million households as well as a reduction in household spending power by an average of 1.25%. While tax increases may be necessary to bring the UK deficit back in line with EU rules such fiscal tightening policies will likely reduce disposable income and consumer confidence, impeding an economic recovery. Consumer confidence is likely to fall back to mid 2009 levels if VAT is increased, according to GFK NOP.

The temporary 2.5% VAT cut was brought in by the former Labour Government as a strategy to encourage consumer spending from 1 December 2008 to 31 December 2009. One would therefore expect an increase in VAT to have the opposite effect and restrain growth in consumer spending. Additionally, consumers tend to be more sensitive to price increases rather than price reductions which suggests that an increase in VAT would reduce consumer spending yet further. According to the Centre for Retail Research, a 2.5% increase in VAT would mean 2.1% would be added to the price of everyday goods in real terms. This would increase the cost of petrol by 2.5p per litre, cigarettes by 12p and a pint of beer by 7p. Furthermore, with 64% of retailers saying they will pass the full VAT increase onto consumers with a month, and 98% within a year, consumers will feel the full brunt of the increase.

Lower income earners are likely be most disadvantaged by the VAT increase. This is because they tend to pay a larger proportion of their gross income in indirect taxes, 28% compared to 14% for the average income earner. 12% of the gross income of lower earners goes on VAT, compared to 7.4% from the average income earner. So although higher income earners pay more VAT in total, the lower income earners will be proportionally worse off.

Inflation and interest rates
UK interest rates have remained at the artificially low rate of 0.5% for a consecutive 14 months to April 2010. Pressure will begin to mount on the Bank of England to increase interest rates as inflation climbs higher. Inflation is currently at 3.4%, some way above the upper sanctioned limit of 3%. Historically, there has been a time lag between rising CPI inflation and when the Bank of England adjusts interest rates. In the current circumstances an interest rate rise appears unavoidable towards the end of year, which is likely to have a significant impact on consumer spending.

Growth in disposable incomes and levels of household savings tend to be indicative measures of consumer spending. Official figures from the ONS reveal that the UK’s household saving ratio has increased at a faster rate than real growth in household disposable incomes during 2009 with the trend looking to continue. This indicates that British consumers have an increasing propensity to save, despite the low interest rates. This tightening of belts and storing of reserves may be in anticipation of the inevitable interest rate rises, tax increases, employment insecurity and public spending cuts.

Public spending cuts
Public spending cuts are also at the top of the new government’s fiscal agenda. The Conservative and Liberal Democrat coalition has already announced plans for additional spending cuts of approximately £6bn to address this. According to the Centre for Economic Performance, the UK’s deficit has historically represented 7-9% of GDP, which is unsustainably high. In 2010, with the deficit forecast to reach £180bn, this accounts for 12.8% of GDP. Observations over the last 10 years show that public spending has increased exponentially, whilst the trend in tax revenues and GDP have been more closely aligned following a zigzag pattern. The differential is estimated to be as much as 10% of GDP over this period, hence the urgency for public expenditure to be curtailed. Unfortunately, this means consumer spending will be impacted significantly.

While specifics of major public spending cuts are yet to be announced, the following have been proposed:

• The withdrawal of government payments to the Child Trust Funds which are payments of between £250 to £500 per child.
• Potential freezing or capping of public sector wages
• Reviewing the default retirement age to allow those who wish to continue to work to do so
• Various tax cuts and changes to income tax thresholds

Generally, cutting public spending is a fiscal tightening strategy employed to reduce consumer demand and in this case, an attempt to realign government expenditure with the country’s receipts and GDP. For instance, the proposed upward revision to the default retirement age will encourage people to work for longer which will help alleviate the drain on government funds and resources. Care, however, needs to be taken to ensure that raising retirement ages does not restrict the entry of youth into the workforce. This is an example of the balancing act required by the government to reduce spending without impeding economic growth and increasing costs in related areas such as job seekers allowance.

Freezing or capping public sector pay will impact household disposable incomes significantly as the public sector represents a substantial portion of the UK workforce. If pay rises are capped at £400 per annum for all public sector employees, as proposed by the Liberal Democrats, the average disposable income of a public sector employee (£25,428 per annum or £489 a week) would be growing at 1.6% which is below the current rate of inflation of 3%, thereby representing a real-time decline in disposable income. However, the growth in salaries would be somewhat offset by the proposed increase in the tax free allowances from £6,475 to £10,000 by April 2011 increasing the overall amount of disposable income available for discretionary spending.

Tax policy
A number of tax initiatives were implemented by the Labour government which came into effect in April 2010. These include raising the highest tax bracket from 40% to 50%, restricting tax allowances on pension contributions for people earning over £150,000, and withdrawal of personal allowances for individuals earning over £100,000. The new government is expected to keep these initiatives, hitting the high income earners most but only making a dent (0.11% of GDP) on the deficit and consequently a minimal impact on consumer spending.

Capital gains tax is also likely to be a victim of reform, being extended from the current CGT of 18% to the higher income tax rate of 50%. The main driver behind reducing the tax differential is to discourage those earning more than £150,000 per annum from switching income to capital, thereby avoiding payment of taxes. This too, is not expected to impact the deficit or consumer spending. 3.6m people are set to benefit from the Liberal Democrats proposal to increase the current tax-free allowance from £6,475 to £10,000. Although this would deprive the treasury of a further £17bn, it does provide a handout to lower income earners who would be hardest hit by the VAT and interest rate rises as well as other measures.

Freezing national insurance which is paid by both employers and employees is expected to avoid unnecessary increases in unemployment and help minimise shrinking take-home pay cheques. This is set to encourage employment and increase consumer spending. There is a general pessimistic view of how these tax measures will impact consumer spending. With a tightening tax policy there will be some relief for low income earners as a result of the tax free allowance and freezing of national insurance but this is more than likely to be offset by tax rises elsewhere. Consumers in all demographics are going to have less disposable income and be more selective of the how then spend it.

Retail sales
Retail sales are often regarded as a bellwether of the economy. Uncertainty looms over retail trading conditions for the next 12 months as the new coalition implements a series of fiscal tightening policies to reduce the budget deficit. All these policies will have an impact on consumer spending which will be felt worst on the high street, both with retail sales and employment. While 56 of the UK’s biggest retailers recognise the need to reduce the budget deficit, many, according to the Centre for Retail Research, have concerns over how the possible VAT increase to 20% would impact on trade.

The retail sector is a critical driver behind the growth in the UK economy. According to the British Retail Consortium, retailing accounts for approximately one third of total consumer spending and is also the largest private sector employer in the UK with three million people working in retail full time or part time. Aside from contributing to a significant portion of the country’s GDP, the retail sector is a large generator of tax revenue earnings for the government. It is estimated that a VAT increase to 20% will enable the government to collect additional taxes of £4.5bn. However, this is set to cause retail sales growth to decline by 0.64%.

In a survey by the Centre for Retail Research, it was revealed that 77% of retailers felt that a 20% VAT on their profits and cash flows would be either very negative or quite negative, with 73% of the view that there would be a negative impact on overall sales. In addition to this, retailers considered hastening plans to reduce workforce numbers if a VAT increase materialised. 1.6% of existing retail employees are set to lose their jobs as a result of the possible VAT increase, 47,360 people, having a knock-on effect of restricting consumer spending.

Online retail is set to benefit as a result of the high street’s woes. High street stores are expected to pass on the full VAT increase to consumers whilst online retailers are less likely. This is set to accelerate the migration online with consumers attracted to cheaper products. This represents a significant opportunity for the online retail sector. E-commerce is currently forecast to grow at 12.4% in 2010-11 but could reach as high as 15-17% after taking the VAT increase into consideration.

Consumer spending is largely driven by the growth in disposable income, consumer confidence levels and the propensity to save. During the last 12 months, real household disposable income growth was maintained despite the challenges of rising unemployment and slower wage growth mainly due to lower interest rates. However, looking to the next 12 months, household disposable incomes is likely to be squeezed as consumers are faced with increasing prices across most product categories from retailers. The household savings ratio has also increased exponentially as consumers are utilising more of their savings to alleviate existing debt by paying down mortgage and debt interest payments. Although the economy is in a period of recovery, consumers are still spending conservatively and would be disinclined to incur further borrowings. Consequently, most retailers are maintaining a very cautious trading outlook in the next 12 months in anticipation of consumer demand and spending being somewhat reduced.

Conclusion
Everyone seems to agree that the deficit needs to be cut. When the measures start to be implemented and greater austerity becomes real, attitudes may change. Individually these measures would most likely pass without consumer spending being too affected. If a VAT increase, interest rate rise, cut in public spending, job cuts and new tax policies are introduced at the same time, this would compound the impact. A VAT increase to 20% is expected to reduce household spending by £425 per household and impact lower income earners the most. It would also result in a 1% decline in retail sales and nearly 50,000 retail job loses. An interest rate rise is likely to have the biggest impact with discretionary income and savings being diverted to help pay increased mortgage payments. Freezing or limiting public sector pay translates into an actual decline in disposable income when inflation is considered. Other measures, such as increasing the retirement age and cutting public sector budgets, are likely to result in rising unemployment.

There is no viable alternative. These measures are necessary for the long term viability of the UK and, if consumer spending is impacted in the short term, then so be it. The new cabinet has signalled this already by announcing their pay will be reduced by 5%. The general pain for the rest of us is likely to be higher than that.