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The transcript for ICAEW Insights podcast episode 29: 'The pain – and potential gains – of rising inflation'.

Philippa Lamb: Hello and welcome to the ICAEW Insights podcast, with news and analysis from the world of accountancy, business and finance. I’m Philippa Lamb, and in this episode we’re looking at inflation, capital allowance reform and the ongoing delays to R&D processing, with Martin Wheatcroft, who’s a financial strategy consultant and adviser on public finances to ICAEW, and ICAEW’s technical manager on business tax, Richard Jones. Inflation is rising at a record pace across the world, triggered by the pandemic and exacerbated by a perfect storm of global events, including the war in Ukraine. Now, while there are some benefits to high inflation, overall, the impact will be significantly negative, particularly if the situation persists beyond the short term. So, what are the specific causes of inflation? What are the potential economic impacts? And what will it mean for public finance? Martin Wheatcroft is with me now. Thanks for coming in. Martin.

Martin Wheatcroft: You’re welcome. 

PL: Now, inflation has shown very little sign of slowing up, if any. How high do you think it could go?

MW: Well, the Bank of England think that it could go as high as 11% and they’re very much hoping that it will peak and then start to come down next year. You’ve got a huge amount of pressure on prices: there’s the post pandemic demand that’s driving what was an economic recovery; you’ve got the energy supply problems with the Russian sanctions and refining capacity problems; and you’ve got significant supply constraints, particularly in China, and with the Ukraine war affecting food. Monthly inflation is sort of picking up, we’re now sort of getting towards 1.5% a month, and in theory that should slow down as last year’s inflation starts to drop out of the numbers. 

PL: Okay. 

MW: And that’s why the Bank of England think it will peak and then come back down next year. But they are concerned about a wage price spiral where wage demands start to push up inflation even more and keep the cycle going.

PL: So how are policymakers responding to this? 

MW: Well, the first thing is higher interest rates from the Bank of England, and they describe this as taking the foot off the accelerator. They’ve had the foot on the accelerator of low interest rates trying to boost the economy for a decade or more. 

PL: Sure.

MW: So, they’re taking the foot off the accelerator, they are starting to raise rates, but they haven’t yet got into the stage of really constraining demand and getting interest rates up to a to a higher level. 

PL: They’ve been cautious, haven’t they? 

MW: Yes, they have. The government is trying to control wages, particularly in the public sector, where they have some control, and encouraging what they call sensible wage demands. How successful that’s going to be, well, we’ll have to wait and see. Governments are also trying to persuade OPEC and the oil- and gas-producing nations to pick up production, as oil and gas prices are one of the biggest drivers to what’s going on with inflation. And private sector should respond to market signals – if prices are going up, that means that there’s an opportunity for the private sector to come in and sell more or take advantage of those higher prices, and that should improve supply where demand is the issue.

PL: So, we look at the broader economy. What’s this all going to mean?

MW: Well, for household budgets, it’s a whole mixed picture. For some, it’s just a matter of spending the savings we built up during the pandemic. For many people who worked from home, no longer had commuting bills, etc, quite substantial sums were built up. And we are seeing some of that, that’s one of the drivers of inflation, with people now going on long-delayed holidays, etc. 

PL: Not everyone’s so fortunate.

MW: But not everyone was so fortunate, and there’s a severe squeeze at the lower end of the income scale going on. And there’s an expected slowdown in the housing market, which has been hot for several years. But as interest rates rise… 

PL: Yes, and mortgages get more expensive… 

MW: …and mortgages get more expensive, yeah.

PL: What about business? 

MW: There’s a real dilemma for business because you’ve got higher input costs going on, and do you increase prices or not? You’ve got wage demands and higher cost of borrowing, which will affect your investment decisions, whether investments are likely to pay back. So, what that means for the economy is difficult to tell, because there are millions of businesses all making decisions based on a very different environment than it was a few years ago.

PL: Yeah, I mean, it’s a complex picture, isn’t it? So, a combination of high inflation, potentially higher interest rates – what’s that going to mean for government in the public finances, do you think? 

MW: Well, there’s a short-term and a long-term aspect to this. In the short term, the Treasury has some real dilemmas at the moment: you’ve got wage demands; strikes, obviously, that we’ve seen recently, and they are likely to pick up; and you’ve got higher procurement costs, and that’s going to really affect the ability of government to deliver things they’ve said they’re going to deliver. And if you think about the capital investment programme, for example, the government increased that by 10% in the spending review last year. But now that 10% extra money is just going to be absorbed by inflation and won’t actually deliver extra infrastructure on the ground. 

PL: And they’re going to be looking for efficiency savings? 

MW: Exactly. So, there’ll be a lot of lobbying for more money from government departments, and the Treasury is likely to cave a little on that. But you do have the extended disruption that’s likely from strikes, as that happens, and you’re going to have issues about delivery of, for example, government’s levelling-up plans, where money is not just going to go as far as it has.

PL: Yes, we talked about this in a previous podcast. You can see how that’s going to be an issue.

MW: Particularly where you’ve got a government that’s very keen on getting ready for some tax cuts ahead of the next general election. They’re looking for savings, they’re looking to find money, and all around them you’ve got cost pressures really coming home at the moment.

PL: Yes, I mean, the general election isn’t that far away now, is it? So presumably, the pressure for that is mounting?

MW: It is. And I suspect that it’s just a matter of time before we get some announcements on that side. There is another side to this, which is a longer-term side, so there is one big benefit of inflation from the public sector finances perspective, which is that your GDP goes up much, much faster, and that brings down your debt to GDP ratio. That’s the key metric that government really uses to know how it’s doing. So, a year or two of inflation, of high inflation, is actually quite good from a treasury point of view, even if it brings with it lots of short-term pain.

PL: You are mentioning a point about quantitative easing, then?

MW: Yes, quantitative easing has had the effect of pushing down interest rates. It’s a very big interest rate swap that has swapped a lot of government fixed-rate debt along maturities into short-term Bank of England deposits, which pay the Bank of England rate. And as interest rates go up, and as the Bank of England tries to control inflation, it will start to unwind its quantitative easing programme, and that will start to push up interest rates even more. So, it’s an accelerator to the whole process, which means that we are going to see a very different economic environment over the next few years.

PL: There are a lot of negatives. Do you see any benefits to this period of high inflation, particularly from a corporate point of view?

MW: Yes, I mean, high inflation has some real benefits to allow businesses to adjust in a way that they can’t in a period of low inflation. So, it’s much easier to give someone a salary rise that’s slightly lower than inflation than it is to cut their pay. And that allows business to adjust and respond to different market conditions in a way that is much more difficult in a period of low inflation.

PL: Similarly, that presumably means that pricing levels are a bit more easily adjusted, too.

MW: Correct, yes. So, businesses that may have struggled to put up prices may find it a lot easier to put up prices. If all your competitors are putting up prices, you can adjust your prices in a way, and particularly address products, for example, or services where you’ve been underpricing for a while and found it difficult to adjust in the face of the market conditions. Now’s the time to fix that. Obviously, there’s a downside from the consumer perspective, as we know.

PL: Indeed, and we’ve got this acceleration in the reduction of debt to the GDP ratio you mentioned earlier.

MW: And that’s very good news for the government, as I said, in the in the longer term. It does bring debt a bit under control – we’re still on an unsustainable path for the public finances – it really helps in the in the longer term to bring it down. But at the expense of making us all a little poorer.

PL: Yes, because I think, generally, high inflation is not a good thing, especially if it persists right across the board. The effect is adverse.

MW: It is. It shakes up the economy. There are some opportunities there to take advantage of that, but it comes with a lot of difficulty, particularly at the lower end of the income scale, affecting living standards. It drives industrial disputes, as we’re seeing, and it becomes very, very painful if it gets out of control. We’re hoping it will start to come down next year. And that’s certainly the hope of the Bank of England and other central banks. But who knows?

PL: We’re going to move on now to capital allowances. As the end of the super deduction approaches, the government is considering reforms to capital allowances to support and encourage business investment. ICAEW has responded to the government plans and I’m joined now by Richard Jones, from ICAEW’s Tax Faculty, to talk them through and to look at the ongoing delays to R&D processing. Hello, Richard. 

Richard Jones: Hi, Philippa, how are you doing?

PL: Thanks for coming in. Now, the super deduction, that gave companies substantially enhanced deductions on qualifying plant and machinery investments. Why is capital allowance reform being discussed now?

RJ: Well, as you say, the super deduction is coming to an end next year. And so, in the Spring Statement that the chancellor made back in March, he announced what he called a tax plan, and part of that involved looking at ways to incentivise more economic growth. And one of the ways in which the government is looking to do that is to encourage businesses to invest more, particularly in their plants and equipment. And it’s looking at the capital allowances regime as a key driver to ensure that that happens. 

PL: And what are they proposing? 

RJ: So, the government is focusing specifically on the allowances available for plant and machinery. Now, just in case some of the listeners aren’t aware of what that means, it includes things that you would think of as machinery, like machines in manufacturing, but it also includes things like fixtures within buildings, things that you might think of as actually part of the building, like the hot and cold water systems, electrical systems.

PL: Okay.

RJ: And also things like furniture and IT equipment. So, it covers quite a broad range of things. But what it specifically excludes is the building itself. So, what it’s looking at is five alternative reforms, and what it’s done is it’s estimated the likely cost to the exchequer for each of those. Now I won’t go through all five, because we won’t have time.

PL: Sure.

RJ: But they range from increasing the permanent level of the annual investment allowance, which is essentially 100% allowance for plant and machinery, through to actually doing away with the AIA and essentially providing a full revenue deduction for all forms of plants and machinery.

PL: Which sounds generous, but I don’t think you’re that impressed, are you? What’s your feeling about the government proposals?

RJ: When we saw the policy paper, as it’s called, we reached out to our members and volunteers to see what their thoughts were. And a lot of them were saying, well, you know, capital allowances, they’re actually more of a reward for investing rather than incentive. If you think about it, one of the reasons for that is because the benefit that you get from the allowance arises some years after the actual investment is made. And so therefore, it is a little bit more like a reward than an incentive. So, what we’ve been trying to do is get some ideas from our members as to ways in which the regime could be made more incentivising.

PL: Okay, now, I know you’ve made a raft of recommendations. Do you want to run us through the most significant ones?

RJ: So, if I go through some of the things that we’ve been saying in our response, the first thing really is: try to make the system simpler and try to stop making quite so many changes. We’ve noticed, for example, the AIA that I mentioned just now, that’s actually changed six times in the course of 14 years, which if you think, is an average of a change every two years, 

PL: That’s a lot, isn’t it? 

RJ: So, what we’re saying is, if you want to make a change, make a change, but please then keep it the same for at least six or seven years. This particularly affects businesses that are on the margins of whether they’re using up their full AIA. So that will give them a little bit more certainty as to the allowances that they’ve got available. Another thing we’ve been thinking about is: can the government make these allowances a little bit more targeted? And in our response, we’ve been looking at three key things: who, what and where. 

PL: Okay, shall take the ‘who’ first? 

RJ: Yes, sure. So, for example, what are the types of businesses that they are looking to encourage? Is it, for example, manufacturing? And I know, for example, that in Italy, there are specific allowances available to manufacturing companies. Could they copy those kinds of incentives? Also, are they looking to focus more on small businesses or larger companies? Those different forms of business, different size of business, will be impacted by different forms of allowances. So maybe they could be looking where they want to focus their attention. 

PL: Okay. And the ‘what’? 

RJ: What we’ve been thinking about is: what are the government’s other priorities? What are their other policy agendas that they might actually help to benefit through the capital allowances system? For example, the government has a target to reduce the UK net-zero carbon emissions to zero by 2050. So, could it use the capital allowances regime, for example, to encourage businesses to invest in more energy-efficient plant and machinery, for example? But it’s also been concerned about the death of the high street. So, could it provide specific incentives to high street retailers? 

PL: And the ‘where’?

RJ: The final policy agenda we’ve heard a lot from, a lot about from the government, is the levelling-up agenda. 

PL: Yes. 

RJ: So, could it provide specific incentives for specific areas in, well, basically outside of the southeast, so in the north, the Midlands, Wales, Scotland and Northern Ireland. 

PL: And you’re talking about enterprise zones, an old idea. 

RJ: Yes, I mean, that was something that was very big in the 80s. 

PL: Yeah! 

RJ: And of course, one of the most famous of those was London Docklands, which obviously is in the southeast, but that had a huge impact on that particular area, and now it’s a major financial centre, to a large extent helped by the enterprise zone that was set up in the 80s. 

PL: And you’d like to see more of that? 

RJ: Yeah, absolutely. I mean, as I say, focused more in other parts of the country. But we think that by focusing the government’s incentives rather than providing a broad-brush approach, actually focusing on the areas that it wants to encourage, that could actually help to make it more targeted and cost-effective. One of the other things that we’ve been looking at also is how can we make the existing allowances more of an incentive? And really it’s around bringing forward the timing of the benefit. So, for example, moving perhaps more towards grants rather than allowances. And also loss-making companies miss out here, because essentially, if they get an allowance, all that’s doing is it’s making an already existing loss bigger. So, one of the things it could do is model another area of the tax regime, which we’re going to come on to talk about, which is R&D tax credits. So, loss-making companies get a cash-back credit rather than an allowance, so they could potentially do that with the capital allowances and help those loss-making companies.

PL: Interesting idea. Yeah. Shall we move on to these R&D processing questions? Because we’re seeing delays there, aren’t we? What’s causing those delays?

RJ: Yes, so one of the problems that HMRC is seeing is there’s been an uptick in what they’re calling non-genuine claims. Essentially, these are claims which relate to expenditure that either doesn’t exist or that doesn’t qualify for R&D tax relief. 

PL: So, fraud and mistakes? 

RJ: Yes, unfortunately. And so, the Revenue has noticed that, it’s basically taking, it’s adding additional checks to the inquiry process that it already carries out, which is meaning that, at the moment, claims have been turned around in about 40 days, on average, rather than the standard 28-day processing time that they’ve been trying to adhere to.

PL: So, it’s a lot more, isn’t it? What sort of impact is this having on businesses?

RJ: There’s a couple of key things there. Firstly, obviously, businesses and their advisers are going to have to wait longer to have their claims looked at. And that includes totally valid and acceptable claims, including those that have been, already been, through what’s called the advance assurance process. So, essentially, this is kind of a pre-check that the revenue carries out for smaller companies. So, they’re going to be impacted, as well as perhaps more marginal claims.

PL: But I see HMRC has asked that people don’t chase them up, as it just causes more delay. 

RJ: Well, absolutely. And that’s understandable. Because, you know, having worked in a customer-facing environment before, being chased up on something obviously distracts you from doing the real work. So, we understand that plea. 

PL: I mean, what’s your sense – they’re saying they’re hoping to hit 40 days – is your sense that that’s going to happen?

RJ: Well, I guess we just have to wait and see. Obviously, the more resources that they can devote to it, the better. And, you know, HMRC has had a lot of problems with the pandemic, dealing, in particular, with a lot of the pandemic-related reliefs that were made available, which of course now are coming to an end. So, so hopefully, that means that it will have more resources available going forward.

PL: So, the advice for members dealing with these sorts of delays would be…?

RJ: There are a few key things that HMRC has suggested to help with claims. So, the first one is just making sure that you submit your claims correctly. So, make sure that all of the entries that you would need to complete on the R&D section of the CT 600, which is the corporation tax return, are completed correctly. The other key thing, which is really very good advice all the way since the R&D tax relief regime has been in place, is to make sure you submit an R&D report. And basically, what that does is summarises the project that’s carried out, and also all of the expenditure that’s been claimed on. That’s always been a good thing to do, and now more than ever. If HMRC sees a good quality report, it’s probably more likely to be more amenable or acceptable to then something that looks a little bit more suspect.

PL: Clear the path a little bit. 

RJ: Absolutely, yeah. 

PL: And then of course, reviewing the latest guidance. 

RJ: The guidance on corporation tax returns changes every year. And often when you Google it, you’ll see old versions of Revenue’s guidance, so make sure you’re always looking at the most up-to-date version.

PL: Oh, yeah, that’s a useful pointer. 

RJ: Absolutely. 

PL: Richard, thanks very much indeed. Really useful. 

RJ: No problem. 

PL: That’s it for today. Thanks to Martin Wheatcroft and Richard Jones for being with us. We’ll be back next month. In the meantime, if you’ve enjoyed this episode, please do rate, review and share it. And of course, subscribe to ICAEW Insights wherever you get your podcasts, so that you never miss an episode. Thanks for listening.