Why Soaring Interest Rates Are Affecting National Debt and Could Mean Tax Rise

High inflation and rising interest rates aren’t just affecting households, they’re affecting the UK’s public finances too. Forecasts suggest the government may need to implement tax rises to avoid debt spiralling.

According to the Office for National Statistics, at the end of July 2023, public sector debt was an eye-watering £2.57 trillion. That is the equivalent of around 98.5% of GDP.

As the UK pays interest on the debt, and rates are rising, costs may increase significantly.

According to a report by Sky News, the UK has faster rising debt servicing costs than other G7 countries because it has a higher share of inflation-linked debt.

A quarter of the UK’s debt is linked to inflation. As a result, the cost of repaying debt has increased sharply over the last 18 months.

Among G7 countries, Italy has the second largest amount of inflation-linked debt, but at 12% it’s far smaller than the UK’s.

While the pace of inflation is starting to slow, there are long-term consequences that could lead to UK debt soaring.

THE OFFICE FOR BUDGET RESPONSIBILITY HAS WARNED DEBT COULD SOAR TO 300% OF GDP

In its fiscal risk and sustainability report, the Office for Budget Responsibility (OBR) noted that shocks have been a “major driver” of debt so far this century. Unexpected events, including the 2008 financial crisis and the Covid-19 pandemic, have led to borrowing soaring.

The OBR warned that unless the government takes steps to permanently increase taxes or cut public spending it would be on track for “unsustainable debt”.

The report says: “By the end of our medium-term forecast period, we project debt to reach about 100% of GDP, after which it rises to over 300% of GDP by 2072/73.

“If a government wanted instead to keep debt from rising above 100% of GDP over the long term, this would require a permanent increase in taxes and/or cut in spending of 4.4% of GDP in 2028/29.”

If the UK continued to experience shocks at a “similar intensity” to what we have seen so far this century, debt could soar to above 500% of GDP by the mid-2070s – twice the historic high at the end of the second world war.

However, the OBR adds: “One would assume that policymakers would take action before debt would be allowed to reach that level.”

With the next general election scheduled to be held no later than 24 January 2025, prime minister Rishi Sunak is likely to face pressure to set out plans to get government debt under control.

CUTS AND FREEZES TO ALLOWANCES HAVE ALREADY INCREASED THE TAX BURDEN OF MANY PEOPLE

Since becoming chancellor in 2020, and then prime minister in 2022, Sunak has already slashed tax allowances that could affect your plans.

Among the allowances cut are:

Capital Gains Tax (CGT) is a tax you pay on the profit you make when you dispose of certain assets, such as second properties or investments you don’t hold in a tax-efficient wrapper. Previously, individuals could make profits of up to £12,300 before CGT was due thanks to the annual exempt amount. However, this allowance fell to £6,000 in 2023/24 and is set to halve to just £3,000 on 6 April 2024.
Similarly, the government slashed the Dividend Allowance from £2,000 to £1,000 in April 2023, and will cut it further to £500 on 6 April 2024. You might receive dividends from some investments or use them to supplement your income if you’re a business owner.
As well as cutting allowances, Sunak has also announced some will be frozen, rather than rising in line with inflation. Dubbed “stealth taxes”, frozen thresholds mean more individuals will pay tax as their income or the value of assets could rise.

Among the thresholds that are frozen until the 2027/28 tax year are:

The Personal Allowance and the thresholds for paying the higher- and additional-rate of Income Tax
The Inheritance Tax (IHT) nil-rate band and residence nil-rate band.
As a result, workers could see their Income Tax liability rise and the proportion of estates affected by IHT may increase.

Yet, the OBR report indicates that the prime minister may be forced to raise taxes further to reduce debt.

While potential tax changes are often reported in the news, usually, it makes sense to wait for official announcements before you adjust your financial plan – reports can be inaccurate, or the government may change its mind.

Regular reviews with a financial planner could help you assess what potential changes mean for you and what action, if any, you should take. We can help ensure your finances continue to reflect current legislation and upcoming changes alongside your goals.

DO YOU HAVE QUESTIONS ABOUT YOUR FINANCES?

If you have questions about how to make the most out of your money, please get in touch.

A financial plan may help you manage your finances. Whether the government increases tax rates, or allowances provide new opportunities, identifying how they could work for you may be valuable.

Please contact us to arrange a meeting to discuss your goals and how a financial plan could help you achieve them.

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