Market View

The fine line between interest rates and taxation

In 1966, The Beatles and other UK celebrities were protesting against a 95% marginal tax rate imposed by the Labour led government.

Tax and interest rates
Ugnius Litvinskis, Senior Analyst

Let me tell you how it will be;
There's one for you, nineteen for me;
Cause I'm the taxman;
Yeah, I'm the taxman
Source: The Beatles

In 1966, The Beatles and other UK celebrities were protesting against a 95% marginal tax rate imposed by the Labour led government. In the US, the rate was similarly high at the time, at 91%. Very quickly thereafter, shrewd advisors offered their help to reduce this burden. In the UK, you must be a resident in order to pay taxes. So, if you decide to go and live in France or India for six months, you would not be subject to UK taxes. All that sitar playing by Harrison looks slightly different with this in mind. You could also, for example, incorporate your song catalogue and list it on the stock exchange reinvesting your capital gains and dividends, which is exactly what The Beatles did. Over the following decades, governments realised that direct taxation is not very effective and decided to increase indirect taxation, such as VAT and excise duties, instead. Overall, tax income, as a share of GDP, has remained relatively stable over the last fifty years.

As a credit analyst, most of my time is spent on bottom-up analysis of companies, looking at their business profile and financial position. However, sometimes I wonder how small changes at a single company level can significantly affect the overall economy. The steep increase in interest rates over the last twelve months is one of those changes.

Whilst increasing interest payments are going to impact company profitability, it will also directly translate to lower tax payments. This is because interest is considered tax deductible, as long as total interest expense is not higher than 30% of the company’s operating earnings. This could be a factor for smaller companies with higher debt burdens, but the average large corporate in the US or UK is well below this threshold1. For governments, this will result in lower tax revenues collected from companies. At the same time, higher rates are increasing government interest expenses, making the delicate act of balancing a budget more difficult.

Government spending tends to run slightly ahead of income and since the late 1970s budgets have been consistently in deficit slowly increasing overall levels of debt. This could be justified in the past as GDP growth was high, driven by increasing labour pool and productivity growth. Whilst interest rates were gradually decreasing since the 90s, from 2020 onwards, annual budget deficits have increased substantially. First, governments had to rescue economies from the impact of the pandemic, and then, to help people and businesses tackle the effects of inflation and high energy costs. This substantially increased total government debt outstanding2. As interest rates were low, the cost on this debt is low too, but it will become much higher once the debt has to be refinanced at prevailing interest rates. At the current trajectory, US and UK interest payments, as a share of GDP, are expected to reach highest levels since the 1980s by the middle of this decade. The difference being that base interest rates are currently at a level of 4% to 5% whilst in the 1980s they reached as high as 20%.

Budget deficits are expected to reduce from 2025 onwards as GDP growth improves, spending reduces, and interest rates decrease. However, as any analyst knows, trying to accurately forecast events further out than three years into the future is as reliable as palm reading. There are too many variables to account for and so going back to status quo is simply assumed in most cases. However, one does not need a crystal ball to see that governments will eventually need to address their deficits, and this may have to be sooner rather than later if economic conditions do not improve as quickly as expected.

One measure to address this could be to increase the headline corporate tax rate in order to offset lower taxable income. Corporation tax has been very low, based on historical standards. That is beginning to change as countries, such as the UK, have begun raising the headline rate. This could impact corporate profitability on a net profit basis. However, companies will always find clever solutions on how to minimize their effective tax rate.

Given recent industrial action by public sector employees, combined with increasing healthcare costs of an aging population, finding future cuts to fund a higher interest burden will be politically challenging. Future Treasury officials will have to think carefully how to balance the books given past experience with the effectiveness of previous measures.

Even with the 95% tax rate, The Beatles are widely considered to be the band with the highest combined net worth of all time.


1 In 2022, the average interest cover ratio within the S&P 500 was 10x whilst within the FTSE 100 it was 11x

2 US government debt to GDP ratio is expected to be 129% in 2022 compared to 32% in 1980. UK government debt to GDP ratio was 100% in 2022 compared to 38% in 1980. Since 2019, this ratio has risen from 107% and 85% in the US and UK respectively.

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