Department of Economics
STUDENT & UNIT DETAILS – TO BE COMPLETED BY THE STUDENT
13634
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Unit Name and Code
ES10008
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START YOUR ASSESSMENT HERE.
BEFORE YOUR ANSWERS, STATE EXPLICITLY WHICH PART / QUESTION /
SUBQUESTION YOU ARE ATTEMPTING.
Question 1
The UK economy has had a surge of growth in its financial services sector in recent years parallel to its
transformation from an industrial economy to a service economy. The financial services sector contributed
to 6.9% of UK’s total economic output in 2019 (Hutton and Shalchi, 2021). Notably, London is now a major
global financial centre, deeply integrating it in the global economy. This can be seen in the following charts.
The lending provided by commercial banks could be hard to substitute by the capital market, therefore
their collapse could severely damage credit availability throughout the economy (PRA’s approach to
banking supervision,2018). Commercial bank interdependence could also mean that the failure of one firm
can have an amplified effect on many. Considering that the 2008 financial crisis was triggered from the
failure of this sector, the Bank of England (BoE) places a great emphasis on regulating and supervising it to
prevent devastating adverse effects on both the UK and global economy in the occurrence of its collapse.
Microprudential regulation and supervision of individual financial service firms by the BoE is devoted to
its internal body, the Prudential Regulation Authority (PRA) which works closely with the Financial
Conduct Authority (FCA). The PRA currently regulates around 1,500 firms and the breakdown of this
aggregate figure is depicted in the following charts (Business Plan 2020/21).
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Its objectives are promoting safety and soundness and facilitating competition for the regulated firms.
These objectives reflect the reasons for its existence: being to reduce risks to the stability of the financial
sector while also improving consumer benefits through competition. The PRA additionally seeks to limit
potential disruption of the financial system with no wider spillovers and public fund losses if risks crystallise
and firms fail (Business Plan 2020/21).
The PRA has eight Fundamental Rules, multiple Threshold Conditions and publishes Supervisory
Statements which must be followed by its regulated firms. These essentially act as the PRA’s blueprint for
promoting safety and soundness. Moreover, with the PRA focusing on individual firms and with its notable
degree of flexibility, it can tailor its supervision and standards for each firm based on its needs and
magnitude of economic unrest it would cause should it fail (PRA’s approach to banking supervision,2018).
This allows for more effective outcomes on risk-mitigation than a homogenous approach for all firms.
A crucial focus of the PRA’s strategy is firms holding adequate levels of quality assets and liquidity while
managing the risk they undertake effectively (Business Plan,2020/21). Adequate levels of capital
requirements on a non-firm specific level are dictated by the Financial Policy Committee (FPC) via the
countercyclical-buffer rate and sectoral capital requirements (BoE Quarterly Bulletin,2014). The PRA
assesses these capital plans and helps in guiding its regulated firms with interpreting and integrating them.
Additionally, if firms undertake activities which contradict the PRA’s desired supervisory outcome
threatening the stability of the sector, it has the power to intervene with supervisory action and directly
adjust a firm’s strategy or business model (PRA’s approach to banking supervision,2018). An example of
the PRA exercising its power was requesting banks to cancel outstanding 2019 dividend payments to
shareholders as a precautionary step considering the uncertainty surrounding the pandemic (Financial
Stability Report,2020). This was an obligation enshrined by the PRA’s third Fundamental Rule “act in a
prudent manner” (Statement by the PRA,2020).
The PRA and FPA also contribute in designing and running of stress tests used by the BoE. Stress tests are
crucial for the PRA when assessing the resilience of major banks and building societies as they are tested
against an array of tough, hypothetical scenarios highlighting vulnerabilities that may exist in these firms.
The PRA and FPC have carried out two stress tests in 2020 to evaluate the bank’s capital position during the
crisis and have concluded that they are resilient to a variety of economic outcomes (Financial Stability
Report,2020).
The PRA also focuses on evaluating risks which may not be associated with prevailing economic
conditions. Recent areas of interest for the PRA in stress testing have been the risks posed by climate change
and integration of artificial intelligence within the financial services sector (Business Plan,2020/21). Such
risks are assessed by the PRA alongside specialised external bodies for them to be prevented using firmspecific supervisory strategies, ultimately maintaining financial stability.
Challenges for the PRA do also exist. Regulatory return data received by the PRA is submitted by the firms
themselves. This poses data integrity and accuracy to be questioned and paired with issues in processing this
data, it has been a substantial issue. Enforcement actions have been taken in cases where misrepresentation
of data had been exposed and investing in third-party reviews of data is also being considered (Business
Plan,2020/21).
Moreover, due to the nature of the fast-moving environment which firms operate in, a vast array of risks
can be identified. Evaluating and constructing prevention strategies for all of them can put a strain on the
PRA’s budget, especially for risks requiring specialist resources (Business Plan,2020/21). Additionally,
unexpected risks crystallising like the pandemic require costly reprioritisation of the PRA’s Business Plan.
Summarising - the BoE’s body of prudential regulation and supervision of the financial service sector is
the PRA which was set up through the post financial crisis reform to provide greater resilience in this
important sector using standards and policies. Despite some of its issues, it is arguably successful with the
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financial sector demonstrating resilience in the current crisis.
Word count: 900
Question 2
The spring 2021 budget has presented the corporate tax reform which attempts to further support
businesses considering the everchanging developments of the pandemic, while also guiding economic
recovery for the UK. Such major reforms can have an array of effects on relevant entities and overall
economy.
Firstly, we consider the main corporate tax rate, small profit rate and the marginal relief measures. The
alterations on these measures assist the government’s objective of raising revenue and thereby facilitate
reduction of its deficit. According to the Office for Budget Responsibility (OBR), the forecasted impact of
these changes over the coming years is significant and is summarised in the following table.
The benefit for the government is likely to be real as the effective tax rate is forecasted to rise steadily
alongside the headline rate as depicted by the following graph.
This means that the impact of the rise in corporate tax rate outweighs the benefits and reliefs provided by the
government to firms. Small firms being exempt from the higher rate may also be regarded as healthy for
maintaining competition, as that additive burden could potentially have led to bankruptcies in the currently
challenging economy environment. If we assume that smaller firms correlate with lower income households,
this policy may also be considered fair, as such households should contribute proportionally less to public
finances than higher-income households according to the HM treasury.
These policies, however, increase the cost of capital for relevant businesses, lowering the desired capital
stock and investment levels (HMRC,2021). This causes adverse effects on the economy’s long-term growth
as investment is a key driver of it. Such effects can be amplified by behavioural changes from multinational
companies diverting their operations and profits away from the UK. Increased tax burden to firms may also
ultimately be felt by shareholders, employees and customers rather than firms themselves depending on the
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magnitude of their pass-through (Feldmann,2021). According to empirical evidence from the OECD it is
found that corporate tax is the most harmful method of taxation upon growth (Feldmann,2021).
Business investment could remain sufficiently stimulated however, with the temporary higher rates of
relief offered for qualifying assets and super-deductions. These reduce the tax-adjusted cost of capital. They
are estimated to have a substantial impact on 2.8 million firms and are a major contributor to the
government’s objective of investment-led recovery (HMRC,2021). Supply-side policies can stimulate
permanent, long-term growth for an economy and the UK could reap improvements in areas such as
productivity by these measures. Ultimately leading to businesses generating higher revenues due to
improved international competitiveness, contributing to higher government receipts in the medium-run. The
OBR’s estimated impact of these policies are depicted in the table below, presenting positive figures by
2025 with the policy eventually generating enough revenues to offset receipt loses for the government.
It should be considered that the OBR’s estimates must be observed with consideration of the uncertainty
prevailing in the current economic environment. Business confidence is of high importance for such policy
to be effective and risks associated with the new strains of the virus potentially crystalising, impacts
estimated could be largely subdued. More importantly, it is also criticized by the Institute for Fiscal Studies
(IFS) that investment levels facilitated by these policies would not have been otherwise achievable without
these reliefs. This distorts timing of investments by firms and potentially causing benefits experienced by
them to go in reverse in subsequent years (Adam,2021).
Finally, extension to carry back of trading losses for corporation tax will continue to improve cashflow
conditions for relevant firms, assisting in prevention of bankruptcies. This is of value to the economy as
collapsing of firms would further dampen economy growth and increase redundancies. Thereby, intervening
with economic recovery and worsening the government deficit through reduction of income tax receipts and
potential increased spending on laid-off workers. This policy is also encouraged as “profit in one year and a
loss in another should be cancelled out wherever possible” according to S.Adam (Feldmann,2021). It is
estimated that this measure will help 130,000 companies and 500 unincorporated businesses (HMRC,2021).
It could be argued however, that such support measure contributes to the “zombification” of firms that
should be left to fail, releasing locked-up resources such as capital and labour into the economy which could
be reallocated elsewhere more effectively. Moreover, this measure is said to have significant implementation
costs for the HMRC due to changes in IT systems and online filling products required, amounting to
approximately £17 million (HMRC,2021). Administrative burden and one-off costs for firms will also arise
due to familiarisation of changes, updating of internal software systems and applications for marginal relief
claims. These costs partially offset the relief they experience (HMRC,2021).
Concluding, the corporate tax reform would likely aid the economy’s investment-led recovery of growth
with the use of super deductions and relief measures, while also increasing overall government receipts
through the higher effective tax rate for large firms. This higher rate places the UK in the middle of the pack
comparative to other developed economies and therefore should not have extreme adverse effects in its
domestic and foreign investment levels. The temporary measures imposed will likely have minor
macroeconomic effects for the UK in the long-run as they are not permanent. Overall, these measures
largely contributing to the OBR’s estimated pre-crisis peak recovery by 2023, but their real effectiveness
being crucially pivoted with the actual development of the pandemic itself.
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Word count: 899
Reference List:
Question 1:
➢ Bank of England, 2014, Bank of England Quarterly Bulletin 2014 Q4, London: Bank of England,
available at: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/theinteraction-of-the-fpc-and-the-mpc.pdf
➢ Bank of England, 2018, The Prudential Regulation Authority’s approach to banking supervision,
October, London: Bank of England, available at: https://www.bankofengland.co.uk//media/boe/files/prudential-regulation/approach/banking-approach2018.pdf?la=en&hash=3445FD6B39A2576ACCE8B4F9692B05EE04D0CFE3
➢ Bank of England, 2020, Statement by the PRA accompanying measures announced by the Financial
Policy Committee, March, available at: https://www.bankofengland.co.uk/prudentialregulation/publication/2020/statement-by-the-pra-accompanying-measures-announced-by-the-fpc
➢ Bank of England, 2020, Financial Stability Report, December, London: Bank of England, available
at: https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2020/december2020.pdf?la=en&hash=876D253A7E169E6462692A41101AA698E7897EA1
➢ Bank of England, 2020, Prudential Regulation Authority Business Plan 2020/21, London: Bank of
England, available at: https://www.bankofengland.co.uk/-/media/boe/files/prudentialregulation/publication/2020/pra-business-plan-202021.pdf?la=en&hash=E23F1E913C33C7DD506D7CEB3A29A3101F07E315
➢ Hutton, G.H, Shalchi, A.S, 2021, Financial services: contribution to the UK economy, Published by
UK parliament, available at: https://commonslibrary.parliament.uk/research-briefings/sn06193/
Question 2:
➢ Adam, S.A, 2021, Business tax changes, Institute for Fiscal Studies, available at:
https://ifs.org.uk/uploads/Business-tax-changes.pdf
➢ Feldmann, F.H, 2021, Corporate Tax Reform 2021, University of Bath, unpublished. Available on
Moodle
➢ HM Revenue & Customs, 2021, Corporation Tax charge and rates from 1 April 2022 and Small
Profits Rate and Marginal Relief from 1 April 2023, available at:
https://www.gov.uk/government/publications/corporation-tax-charge-and-rates-from-1-april-2022and-small-profits-rate-and-marginal-relief-from-1-april-2023/corporation-tax-charge-and-rates-from1-april-2022-and-small-profits-rate-and-marginal-relief-from-1-april-2023
➢ HM Revenue & Customs, 2021, Temporary extension to carry back of trading losses for Corporation
Tax and Income Tax, available at: https://www.gov.uk/government/publications/temporaryPage 6 of 7
extension-to-carry-back-of-trading-losses-for-corporation-tax-and-income-tax/temporary-extensionto-carry-back-of-trading-losses-for-corporation-tax-and-income-tax
➢ HM Treasury, 2021, Budget 2021- Protecting the jobs and livelihoods of the British people, available
at:https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/
966868/BUDGET_2021_-_web.pdf
➢ Institute for Fiscal Studies, 2021, Budget 2021, available at: https://ifs.org.uk/budget-2021
➢ Office for Budget Responsibility,2021, Economic and fiscal outlook, March, CP 387, available at:
https://obr.uk/efo/economic-and-fiscal-outlook-march-2021/
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