EU budget row: How much interest will the UK pay if it refuses to cough up?

300% interest - in the EU it is legal

As most of you will know by now, the European Commission has asked the UK to pay an extra £1.7bn surcharge into this year's EU budget - before December 1. David Cameron has said he won't pay anything "near that amount", which in turn has triggered an almighty stand-off with the Commission itself insisting that if the UK fails to pay, it'll be charged interest from day one.

There has been a lot of confusion as to how much interest the UK will be legally liable to pay if it follows through on David Cameron's threat to refuse to pay. The answer as always lies in an EU Regulation as we pointed out here.

So how much is it? The short answer is a lot. Let's say Cameron holds out for one month. He'll then owe the EU £3.5 million in addition to the original £1.7bn surcharge. If he holds out for six months, UK taxpayers are looking at an additional £39.1 million while one year will increase the bill to £89 million - the annual interest will then stand at 5.25% . If the debt is still outstanding after 10 years, the UK would owe an eye watering £5.5bn of interest on a £1.7bn debt - over 300% interest.

In other words, under EU rules, the penal rate is ever increasing.

This is how it is worked out. Firstly the regulation states an annual interest rate of 2% above base rates per year - making a current 2.5%. It's worth keeping in mind that this is much more than the UK pays itself to borrow (in maturities up to 12 years or so, see UK yield curve here). However there is a sting - a rising penal rate of 0.25% for each outstanding month, and the total interest is all paid at the higher rate. This quickly adds up as you can see below:

So if this drags on, it has the potential to really become messy. However, as with everything in the EU there is usually a political solution. The Netherlands and Italy are also upset at receiving demands while the calculations (particularly around the interaction with the UK rebate) and the EU amending budget that goes with it are still up for 'clarification' and/or amendment. As reports today also indicated, it seems likely the UK will be able to do a face saving deal to pay something more than zero and less than £1.7bn - but if not the implications are huge.

Growth in UK economy to increase EU 'stealth tax'

It's that time of year again. Chancellor George Osborne has delivered his latest budget. The EU geeks that we are, we have one question in mind: what does it say about the UK's contributions to the EU budget?

Well, as ever, this is complicated because there are lots of ways of measuring these contributions. The table below shows the main figures and how they compare to the OBR's previous estimates in December 2013 (click to enlarge):

It shows that the UK's total net and gross contributions to the EU budget are now expected to be around £2.3bn and £1.7bn higher over the next six years than previously forecast. However, the impact of this on the OBR's figures for the Government's Total Managed Expenditure (TME) and Public Sector Net Borrowing (PSNB) as shown in the Budget is neutral or even slightly positive over the same period, compared to the December forecast.

One of the reasons for this is that the OBR effectively treats the contributions that the UK makes to the EU via a share of VAT receipts, customs duties and sugar levies as a direct "EU tax" and the money therefore doesn't show up in the national accounts. UK contributions are also affected by the complex rebate calculations and how much the UK receives from the budget.

As the UK economy is now growing faster than others in the EU, the overall UK contribution increases. But because the rebate is calculated on the basis of the UK's VAT contributions and the UK gets a refund on some of the customs duties it collects, that will help reduce direct contributions from the UK Government's budget and balance out this figure over the six years.

Relative to GDP the increase is tiny and the good news is that it's due to a faster growing economy.  Nevertheless, UK plc still ends up contributing more due to the growth in the 'EU's tax base'...

'Budget Deadline Day' in Europe

As you may have noticed, yesterday saw numerous governments across Europe unveiling their latest budgets for the coming year. Rather than just being a coincidence, this is down to the fact that yesterday was the deadline for eurozone governments to submit their budget plans to the European Commission – 'Budget Deadline Day', if you will.

As part of the ‘Six-pack’ set of rules, eurozone governments must have their budgets endorsed by the Commission, although the ability to actually force changes to the budget plans is limited for those countries which are not missing their targets already (except for significant peer pressure).

As with football’s transfer deadline day, there were some frantic negotiations, albeit without the minute to minute media coverage. Below, we take a look at the budgets of the Italian, Irish and Portuguese governments.

Italy
Italy yesterday unveiled its new ‘Stability Law’ – the budget guidelines for 2014-16. There’s some encouraging stuff in there, notably a package of tax cuts for businesses and workers worth €10.6bn over three years (of which €2.5bn to be cut in 2014). Nothing massive, but it's a start. The money to cover for these cuts is due to come from a number of public spending cuts. However, the draft budget will now have to be adopted by the Italian parliament, and some of the measures may change.

Prime Minister Enrico Letta has confirmed Italy aims to bring its deficit down to 2.5% of GDP by the end of next year. That said, the problem for Italy remains its weak growth – which in turn threatens its fiscal targets. Last week, for instance, the Italian government had to adopt a set of urgent measures to find a further €1.6bn and make sure the deficit stays below 3% of GDP this year. Unlike other countries, the budget may hold less importance for Italy’s economic future with the focus now on much needed political reform and improvement in the business environment.

Ireland
Debate over the Irish budget has been going on for some time, and the government managed to secure a lower level of headline cuts than expected ahead of time - €2.5bn compared to €3.1bn. However, the budget remains controversial with the Irish Independent running the front page headline, "Unkindest cuts", because they fall on pensions, healthcare and unemployment benefits for young people.

For the most part, although this budget was about tinkering around the edges rather than making the huge cuts we have seen before, the government focused on adjusting lesser known taxes to reap numerous small savings. Interestingly, the government also committed to reducing tax evasion and tackling the view of the country as a ‘corporate tax haven’. It will be key to see if this impacts the number of multinationals locating in Ireland and if it has any knock-on impact on economic growth.

Portugal
Of the three, this is probably the most concerning budget. Following a difficult summer for Portugal, politically at least, the government has once again been forced to find a further €3.2bn in cuts. However, the government has once again taken the same approach by heaping the cuts of public sector workers pay (up to 12% in parts) and on pensions. Action on these areas is needed. However, it has also been repeatedly struck down by the Constitutional Court. This might be setting the scene for another showdown.

This has evoked concerns from within the Commission, and it will be interesting to see whether a full endorsement is forthcoming. Portugal also confirmed it will miss this year’s deficit target and the continuing push to ease next year’s target suggests little confidence that it will meet that one either. The good news is that Portugal’s borrowing costs remain well below their peak, and some market access once it exits its bailout next year seems likely. That said, unless it can get a hold of the public sector reform needed, some additional aid still looks likely.

Overall then, a bit of a mixed bag. Few marquee measures, but some positive moves in terms of focusing cuts on spending rather than tax hikes.

Open Europe publishes (and analyses) leaked draft of Van Rompuy's new EU budget proposal

We’ve got our hands on a leaked copy of the latest HermanVan Rompuy (HvR) proposal for the EU budget (see here for the full doc). The headline spending figure remains broadly unchanged in the new proposal, standing at €1,014bn (a €4bn increase), but more cash is spent on farm subsidies and structural funds, in a move designed to appease France, Poland, Italy and Spain.

(The figures here includes off budget items, if they are discounted the second proposal is actuall a decrease, from €973bn to €972bn. This is mostly due to items which weren't off budget in the original proposal, being off budget in the second version).

No figure is given for payments appropriations – the figure that the UK government is targeting – but given that this figure has widely been cited to be €940bn, it’s likely that it’ll have to come down more if acceptable to the UK (with the government's initial proposal at €886bn).

Also, just like with the previous draft, the latest HvR proposal foresees cuts to the UK rebate – which is a non-starter for Britain.  As a refresher (from our recent flash analysis):

“The proposal also includes an adjustment in the way in which the UK rebate is calculated. This could result in the UK rebate falling by as much as 11% or €3.5bn across the next budget period, solely due to this adjustment.

The plan also suggests that ‘corrections’ such as the UK rebate will be “fully financed by all member states”. It’s not entirely clear what this means, but it does suggest that the UK could actually be responsible for funding part of its own rebate. If this were the case then the rebate could be reduced by a further €3.316bn, cutting the rebate by a further 11.5%, and 21% (€6.8bn) from its original amount.”

The increased spending on CAP and Cohesion moves further away from the spending split which many in the UK would like to see (more growth focused) while although the headline figure has not increased it is still probably slightly too high. See table below for the full break down (click to enlarge):

So, despite talk of progress last night, it still seems that, from a UK perspective (but also likely a Swedish, Dutch and German one) there are some significant divisions.
 

The confusion of EU budget maths

Confused by the various figures flying around in the EU budget talks? When is a freeze a freeze and not an increase etc? Don’t feel bad, everyone is confused. There are a number of ways to calculate the increase or otherwise in the EU budget, depending on whether one looks at:

• payments or commitments
• net contributions before or after rebate
• gross contributions before or after rebate
• on-budget items only or also EU spending outside the main budget
• Current prices or constant prices 

In other words, enough to do your head in. Heading into tomorrow’s negotiations on the EU budget there are essentially two crucial elements to take into account when considering whether Cameron has managed to deliver what he has promised (a real-terms payments freeze): the level of “payment appropriations ceilings” versus “commitment appropriations ceilings”; and share of EU spending covered by UK’s rebate.

The first point is tricky because the UK Government has set its stall out using different measurements to everyone else.

Every annual EU budget includes a figure for ‘commitments’ (which are essentially ‘promises to pay’ or funds that can be earmarked that year) and ‘payments’ (the level of money actually paid out in the given year). The long-term budget on the other hand, which is being discussed tomorrow, includes ceilings that limit the maximum level of commitments and payments that can be made in the years 2014-2020, with payments always lower than commitments.

Now, all the plans on the table at the moment, except the UK’s, compare proposed commitment ceilings for 2014-2020 to the previous long term budget’s commitment ceilings for 2007-13. The UK has taken the level of payments from the 2011 budget (i.e. the money actually spent that year) and, after scaling the figure up to cover the full seven years, used this as its baseline. This helps explain the very large gap in the UK’s proposal compared to the others. Using everyone else’s baseline (2007-13 ceilings), the UK proposal looks a lot more like a real terms cut than a freeze.

Reports overnight suggested that the UK was ready to negotiate a deal based on the Herman van Rompuy (HvR) proposal – on the surface this looks like a significant U-turn given that the UK’s proposal totals around €886bn in payments compared to €1011bn in commitments under the HvR plan. However, this is comparing payments with commitments. New reports suggest that the new version of the HvR proposal includes a payments ceiling of around €938bn, significantly closer to the UK’s position and a slight real terms cut on the current payments ceiling (€4bn). This then is the figure to compare. This figure is likely to have to come down further to be accepted by the UK. But, although it wouldn’t be ideal, David Cameron might be able to sell this as a ‘cut’ or ‘freeze’ at home, because on everyone else’s terms it would be.

The main stumbling block with the HvR proposal falls under the second issue – the rebate. Currently, the plan would change the way the rebate is calculated, removing the UK’s compensation for ‘rural development’ spending in the new member states and requiring the rebate to be funded by all member states (including the UK). We estimate that this could cost the UK between €3.5bn and €7bn over the seven year period – this clearly makes it unacceptable to Cameron, who has pledged to defend the rebate. However, this proposal to change the rebate would appear to be a straw man to knock down (a domestic win for Cameron).

This is because, as we noted a few weeks back – featured by Newsnight - the UK rebate is already set to fall by a similar amount, simply by virtue of the way money is likely to be allocated in future and the way the rebate works. More money is set to go to the newer (poorer) member states and this means there will be less spending on which the UK receives a rebate. This means that the UK net contribution to the EU budget could rise even if there is a freeze or a small cut in the budget. This is unavoidable and much a result of previous rebate negotiations under Tony Blair.

Overall, the UK could end up with a deal where its net contribution increases (due to a fall in the rebate) and the overall budget is above its desired target. But, this is not as bad a deal as it might appear and could still represent a real terms cut in the budget (on all the other member states’ and the European Commission’s baseline). Of course a lot could still happen in the coming days.

That said, the EU budget remains an anomaly and an insult too all economic common sense. We would still much have preferred the UK to push for wider reform of the EU budget in terms of content as well as size, especially since (as our recent blog showed) plenty of other countries were upset at the potential spending increase.  The simple fact that we need to explain all of this speaks volumes about how the UK Government has communicated its strategy. It failed to properly express what it’s position was and why, which has probably made it more difficult to explain its position to both its EU partners and the general public alike. This could cost the Government when it comes home with a deal. 

Initial thoughts on Spain's latest austerity budget

We’re still waiting for the full breakdown and figures behind the Spanish budget (which we will analyse and post in due course) but in the meantime here are our initial thoughts:

• The decision to tap the pension/social security reserve fund for €3bn was surprising. Generally this is a fairly last resort approach, but why Spain felt the need to do this to get its hands on only €3bn isn’t clear, especially with short term borrowing costs still low. Could Spain’s liquidity problems be greater than thought?
•  The interest Spain will have to pay on its debt will go up by €9.7bn, compared to a total package of cuts of €40bn (undoing almost a quarter of them). For a country the size of Spain even seemingly substantial cuts can easily be offset by the massive debt burden.
• The majority of the savings (58%) will come from spending cuts rather than tax increases – there is an on-going debate over which is more effective but in the short term spending cuts are likely to harm economic growth (especially given the reliance on the state as an economic driver in Spain).
• Tax revenue is expected to go up by 3.8% - given that growth is likely to falter this seems incredibly optimistic, even with some tax increases.
• The basic macroeconomic forecasts for the budget haven’t changed – this suggests that the overly optimistic growth forecasts are likely still in place, despite most investors and international agencies reducing their forecasts.
• Unemployment is predicted to have topped out this year – again this seems hopelessly optimistic given that structural labour market reforms are yet to take full effect (and there are still more to come) while internal devaluation will need to continue at a rapid pace (see our recent briefing here for more info on this).

So, plenty of issues already, with what seems to be a fairly unconvincing budget given the state of the Spanish economy. 

One final point to note is that Spanish Economy Minister Luis De Guindos kept insisting that the measures were all in line with recommendations from the EU/IMF/ECB troika or in some cases even went further. This looks to be leading into a Spanish reform programme as part of a bailout/bond buying scheme, hinting that Spain may be preparing that request after all.