George Osborne used his Budget this week to double capital allowances for companies. His hope is that the vast cash surplus being horded by UK firms will now be used to boost investment. Will it work?
UK capital investment is far lower than at this stage in previous recoveries, and one of the lowest among the main industrial countries. The reason is quite rational: the cost of machinery has skyrocketed while labour is cheap. Between 1998 and 2007, we had a strong pound.
That caused the price of imported capital goods to fall by a third, while wages rose by over 50 per cent. Result: firms replaced labour with machines.
But after the 2008 crisis, the value of sterling slumped, raising the price of imported capital goods by 30 per cent. At the same time, unemployment caused wage costs to flat-line. Investment halted in its tracks.
Chancellors of the Exchequer did not help. Since 2008, the real value to firms of the capital allowance has declined dramatically. While Osborne garnered headlines from cutting the headline corporation tax rate, he clawed back the money by eroding capital allowances. Result: the effective marginal tax rate on new investments did not fall.
Of course, this week’s doubling of capital allowances is a welcome reversal of policy. It also occurs just as a rising pound is starting to cut the cost of imported German machine tools. Taken together with strong consumer demand, investment levels should rise. My worry, however, is that this investment boost might not necessarily be of the right sort.
Britain’s economic problem is not just too little investment - it is the negative impact of a current misallocation of capital. Since 2008, a combination of risk-averse banks, labour hoarding, low interests rates and quantitative easing has produced a serious misalignment of capital investment. You can see this is the case by the short-run divergence of output, prices and profits across different industrial sectors.
This week the Office for Budget Responsibility (OBR) forecast that Britain’s output gap (i.e. economic spare capacity) won’t disappear till 2018 – a year sooner than it claimed in December. Even that is being optimistic, because you get inflationary supply bottlenecks breaking out in individual sectors long before capacity seizes up across the board. Unless investment is directed to these potential bottlenecks, the general boost to capital allowances will be in vain.
Too early to write off M&S in Next battle
Who now remembers the dark days of 1990 when the share price of retailer Next fell to 7p, and its charismatic chief executive, George Davies, was summarily fired? Yesterday, Next was trading at about 6,700p a share, on the back of a 5.4 per cent rise in sales, and a healthy 12 per cent hike in profits. This provoked a wave of media comparisons between successful Next and wayward M&S.
We should be careful about making such comparisons. Next made more profit from its catalogue and online business than its shops.
Better then to compare Next with online rivals and not the (tarnished) queen of the UK high street. Again, the Next core customer is female and aged 25-to-40, while M&S is strong in the over-50 demographic.
When interest rates rise, Next may find its customers counting the pennies as they struggle with dearer mortgages, while the affluent, retired, babyboomers frequenting M&S are much less circumscribed.