Comment: Market-makers have reason to rue the Budget

`The City stands to lose an important tax loophole worth rather more than pounds 100m a year to its market-makers. In a business which often struggles to make an adequate return, this could make the difference between profits and losses'
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It usually takes a day or two for the full impact of a Budget to sink in, but eventually the City tends to get the message. So it was surprising to see the stock market, having had a night to sleep on it, roaring away yesterday in response to a Budget which on reflection is actually quite bad news for business and the City.

Nobody had a credible explanation for why equities should want to do this. The abolition of tax credits on dividends reduces the yield on UK equities for pension funds from 3.5 per cent to around 2.8 per cent, so logically the market should be falling. With another hike in interest rates just around the corner, the market perhaps ought actually to have been plummeting.

Markets rarely behave in an entirely logical way, however. The fact that shares rose so strongly may have something to do with a little noticed anti-tax avoidance measure that Gordon Brown slipped into the Budget. Again this was a perverse response to this potentially very nasty little incendiary device, since all the talk in the City yesterday was that the move would cost investment banks hundreds of millions of pounds in trading losses on top of the pounds 500m the Revenue has pencilled in for extra yield over the next five years.

Most of the leading players were vehemently denying the scale of these losses yesterday, but their words all rather lacked conviction. A rather different story of panic was told by the growing number City calls to the Inland Revenue yesterday seeking "clarification". The truth of the matter is that most market makers have used their tax exempt status to flog complex long term equity options. Some of these have been used to back the "guaranteed" returns offered by a number of retail funds, thus adding a scare dimension for small investors to the whole story. Others have been sold to wholesale investors.

In pricing the option, market makers have tended to factor in the payment of gross, rather than net dividends. With that loophole now closed, the option becomes worth up to 20 per cent less than it was originally priced at and therefore incapable of delivering the promised return. We'll have to await details next week to learn precisely how these options have been hit by the new rules. Though stories of emergency meetings with the Bank of England might at this stage seem premature, in a worst case scenario it won't be too long before they become a reality.

Whatever the case, the City stands to lose an important tax loophole worth rather more than pounds 100m a year to its market makers. In a business which often struggles to make an adequate return, this could make the difference between profits and losses.

The stock market's willingness to take the abolition of tax credits in its stride is also a curious one, for the effects of this move are very far reaching. Over the next ten years pounds 50bn is transferred from the stock market to the Government. Since there is no such thing as a free lunch, that money has to come from somewhere. Pension holidays that would otherwise be taken by companies will have to be cancelled, previous surpluses will go unrealised and many companies will have to increase their contributions at a cost of up to 2 per cent of payroll a year.

For those on personal pensions who behave responsibly and increase their contributions to make up the shortfall, the measure is equivalent to 2p on the rate of income tax. For the majority who don't, the effect is like a delayed tax, for they face rather lower benefits than they would otherwise have had.

You can argue until the cows come home about the rights and wrongs of this move, and it would ill become us on the Independent, who urged the Chancellor to do it, to now argue that he was wrong. But it certainly all fits rather uncomfortably with the new Government's aim of encouraging long term savings and thrift. For the stock market to be celebrating the whole thing really does rather confirm the "senior Government source" who was recently quoted as saying "the markets are bonkers".

A tough Budget but questions remain

Gordon Brown's main claim about his first Budget was that it was aimed at improving the performance of the economy in the long-term. Just as he had created a framework for monetary policy that would help deliver economic stability, so he was doing the same thing for fiscal policy. Government borrowing would fall during the next five years, meeting tough new rules. "It is very important to recognise that I am taking decisions for the long term," he insisted.

If Mr Brown is genuinely resisting the temptation that afflicts most Chancellors, to manipulate the economy in the short term, he is to be applauded. Fine tuning of the economy via changes in tax and spending has been tried before and failed. It is not a precise enough art to keep growth on a steady course, and besides, frequent changes in the tax system create instability.

There is at least one very good reason to suppose that Mr Brown is sincere in accepting this reasoning. It is that he has handed operational control over interest rates to the Bank of England. If unpopular measures need to be taken to cool the economy, the Bank can be blamed - and it is unlikely to shirk its duty. It is both a sensible move in economic terms and a very astute one politically.

The Chancellor was also right to claim that it was a tough Budget, but the toughness does not stem from the tax increases he introduced. The pounds 6bn headline figure for the increase in the tax burden this year includes pounds 2.6bn of windfall tax which will not in any real sense be money taken out of the economy. It is not going to alter the level of economic activity by the privatised utilities. Most of the rest of the tax increase comes from the abolition of dividend tax credits, which will hit investment in the short term. Consumer spending this year, the likely boom year, will be unaffected by the Budget.

However, the Budget introduced a new element of toughness into public spending plans. Despite the headline increases in expenditure on health and education, they represent only an allocation of money already written in to the plans. There is a bit of truly additional expenditure via the welfare to work programme.

On the other hand, the Treasury has revised up its forecast for inflation next year without changing the cash spending total to compensate. The real expenditure growth outlined in yesterday's Budget is lower even than under Kenneth Clarke's ultra-tough plans. As Alistair Darling joked yesterday: "Iron is the nicest word they use about Gordon and myself."

This kind of toughness is all about setting the public finances on a sustainable footing. As the Chancellor has pointed out, he inherited a doubled national debt and a level of government borrowing too high for an economy operating at full capacity. The PSBR is due to fall rapidly but so it should at this stage of the economic cycle.

So all this is well and good and we shouldn't perhaps be too critical of a Budget which matched these worthy aims which measures which stand a reasonable chance of fulfiling them. But if there was dishonesty in this Budget it was this - it was Gordon Brown's claim that with the boom now in full swing, he is shifting the balance between consumer and investment spending. If anything, his measures will alter the balance the other way, in the short term at least.

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