Kwasi Kwarteng has been warned that further concessions on his mini-budget will be required beyond his U-turn on the 45p income tax rate if the government is to fix its battered reputation in global markets.
City investors welcomed the chancellor abandoning his plan to scrap the additional rate of income tax charged on higher earners, saying it showed a willingness to listen to concerns over the sustainability of the public finances after a week of denial.
However, economists said that retaining the 45p rate will reduce the scale of Kwarteng’s unfunded tax cuts by £2bn a year out of a total package worth £45bn. They said this would still leave the exchequer facing a massive shortfall in receipts unless he backtracks on other controversial measures in his mini-budget or announced politically unpopular cuts to public spending.
“The chancellor still has a lot of work to do if he is to display a credible commitment to fiscal sustainability,” said Paul Johnson, the director of the Institute for Fiscal Studies.
“Unless he also U-turns on some of his other, much larger tax announcements, he will have no option but to consider cuts to public spending: to social security, investment projects, or public services.”
The pound rallied as news of the government climbdown broke, rising by about two cents against the dollar to trade close to $1.13. Although surrendering some of its earlier gains on another choppy day for UK asset prices, the currency is now back above the level seen before the chancellor’s statement just over a week ago.
Borrowing costs on government bonds fell slightly, while City traders scaled back their bets for the Bank of England to increase interest rates above 6% next year – with expectations for a rise closer to 5.5%.
Charles Hepworth, an investment director at GAM Investments, said: “When market trust has been shattered, as we saw last week, the uphill task of restoring credibility is extremely hard and even harder when strategies shift.
“The market currently has little faith that the prime minister and chancellor can restore credibility in the short-term, and this puts further renewed pressure on UK risk assets.”
In a reversal less than 24 hours after Liz Truss committed to the policy, Kwarteng said he would retain the additional 45p rate. It is levied on those earning £150,000 a year, and backbench MPs had criticised the policy for benefiting the richest in society at a time of growing concern over the impact of sky-high inflation on the poorest in society.
While the U-turn will have little bearing on the exchequer, City investors had viewed the surprise abolition of the 45p rate in the mini-budget as symbolic of a wider disregard at the heart of Truss’s government for sound public finances.
Susannah Streeter, the senior investment and markets analyst at Hargreaves Lansdown, said the climbdown could “help reassure the markets a little that the more reckless nature of this new administration can be reined in” in the short-term.
“A big part of the questionable battle plan to try to stimulate growth is being ripped up, which may actually help calm the feverish rise in borrowing costs for companies, homeowners and the government. But the credibility of the government in providing a steady hand on the tiller at a time of such economic uncertainty has been lost, perhaps irrecoverably.”
Economists said other measures in the mini-budget, including a move to reverse the increase in national insurance and a 1p cut in the basic rate of income tax, still meant Kwarteng’s plans disproportionately benefited higher earners.
The Resolution Foundation said the richest households would lose from the 45p U-turn but were still set to gain almost 40 times as much from tax cuts as the poorest households.
Kwarteng is preparing to announce further details of his tax and spending plans in a fiscal statement to the House of Commons on 23 November, when fresh forecasts for the economy and public finances from the Office for Budget Responsibility will also be published.
Should the chancellor use the event to balance the books through lower government spending, analysts have warned it would mean cutting taxes for higher earners while slashing public services on a scale unseen since the days of George Osborne’s 2010s austerity drive.