The ConDem government’s emergency UK budget will be unveiled next Tuesday.
There seems to be a growing consensus among analysts that we are in for an increase in Value-Added Tax (VAT). A jump in the tax from its current 17.5 per cent to 20 per cent would raise around £12bn, or 0.9 per cent of UK GDP, if it’s implemented from January 2011 (JPMorgan estimates).
But it is unlikely it would do so without impacting CPI UK inflation — already above the target level of 2 per cent, an uncomfortable situation for the Bank of England. (Incidentally, does anyone remember the deflationary forecasts made when the last government said it would cut the VAT, in 2009?)
But the VAT increase is also likely to affect RPI inflation — to which index-linked gilts are, well, linked.
Here are some initial estimates from UBS:
A hike in the VAT rate would notably impact the retail price index. The magnitude of the impact would depend on how much of the VAT hike is passed on by retail outlets to the consumer. We estimate that a 1% hike in the VAT, if passed through completely onto the consumer would raise the RPI index for the month in which it gets implemented by 0.55%. In this we have assumed that 65% of the goods in the RPI basket are taxable through VAT.
But the date at which the VAT increase is implemented is also important for index-linked gilts.
UBS sees three possible timings for the VAT-hike:
(a)A VAT hike from 17.5% to 20% in the month immediately following the date of the emergency budget (i.e. in July 2010)3. Note that July 2010 coincides with the month chosen by Spain, Portugal, Greece and Finland to hike their VAT rates. An argument in favour of this scenario is that earlier the rise in VAT, the more immediate the fiscal gains.
(b) A VAT hike from 17.5% to 20% on 1st January 2011 in line with the last VAT hike that took place in 2010 (our central case)
(c) VAT is raised in three stages, with an increase to 18.5% in January 2011, to 19.5% in January 2012 and 20% in January 20133.
Which would make RPI look like this:
UBS also mentions some anecdotal evidence that there have been quite a few buyers of front-end index-linked gilts in recent months — suggesting people are buying ahead of an expected VAT announcement.
Which means that if a VAT announcement weren’t forthcoming on Tuesday, there could be a swift and knee-jerk jump in index-linked yields. A little index-linked depriVATion.
(Sorry)
(And yes it’s a slow news day).
Related links:
Gilty opportunism? - FT Alphaville
Retailers warn over impact of VAT increase – FT
Expecting inflation like it’s August 2008 – FT Alphaville
In-depth: Budget 2010 – FT