In his Budget last week, the Chancellor gave us his honest assessment of the economy. In short, the big spending of the pandemic rescue package ultimately needs to be paid for, and there are two ways to do this: higher taxes, or more borrowing.
As he said, none of us like high taxes, so he has announced a package of measures that include more borrowing – in fact an eye watering additional £450bn of borrowing is currently expected as a result of the pandemic – spread over last year and next year. This money will be mainly raised by issuing government debt (so called “gilts”) – to UK and overseas investors, many of which are bought by pension schemes and other institutional investors.
But could government take a better approach to where they target the debt, and thereby reduce their cost of borrowing, and thereby reduce the risk of further tax rises in the future? I think they can.
For a number of years now, government has preferred issuing “fixed” gilts – in fact the latest proposals are that around 90% of gilts issued will be of this “fixed” variety next year. These gilts pay out interest that is fixed, ie not linked to inflation. The demand for these gilts has been reasonably strong to-date, meaning that the tax payer gets a good deal - this is because the high demand means the government only needs to pay relatively low rates of interest. This high demand has of course been propped up by the Bank of England buying many of these gilts through its quantitative easing program, but many question how sustainable this is. And in the last month the market prices of these gilts has fallen, perhaps because of an expectation of a flooding of the market. This means the tax payer will have to pay higher rates of interest when issuing new debt in the future. And it seems to me that there is an increasing risk that this interest rate goes up further as this pandemic unwinds – costing us all more money.
But the government is missing a trick in my view. The other 10% of gilt issuance – just £33bn in 2021/22 – is going to be targeted at so called “index-linked” gilts. These gilts pay out interest that is inflation linked. And because of this, they are perfectly suited for pension schemes that pay inflation-linked pensions, reducing risk in schemes and thereby protecting workers’ pensions.
This new £33bn is just a fraction of the amount of additional index-linked gilts that pension schemes need. This keeps the cost of buying these index-linked gilts very high indeed, and there aren’t enough to go around. By the way, this means that the tax payer also currently gets a very good deal on these gilts, because lots of money can be raised if pension schemes are willing to pay a very high price for them.
In my view, the low interest rates payable by the tax payer on index-linked gilts are much more sustainable than the low interest rates payable on fixed gilts, given the enormous pent up demand from pension schemes. The demand from other investors, including overseas investors, for fixed gilts, who can also switch to other non-sterling debt, seems more fragile.
So in order to keep the cost to the tax payer to a minimum, reducing the risk of future tax rises, whilst offering better protection to the UK’s pensioners, the government should in my view shift the balance of borrowing significantly towards long term index-linked gilts.
How much difference could this make to you and me? Well based on figures at the end of February, and assuming the Bank of England can stick to its inflation target in the long term, index-linked gilts are already expected to save tax-payers 1% pa (compared to issuing fixed gilts), primarily because of the demand from pension schemes. Over a 20 year period, this could save the tax payer £20bn for every £100bn raised – which is a very significant sum of money when it comes to mitigating future tax increases. And if I am right about the unsustainability of low long term interest rates on fixed gilts, then the savings could be even more significant.