Government's U-turn on scrapping 45% tax rate: Here's what it means

After a week of criticism for slashing the top income tax rate of 45%, Liz Truss' government has taken a U-turn on the decision. In an early morning tweet on Monday, Chancellor Kwasi Kwarteng said that the move to abolish the tax rate had become a "distraction" from the overriding mission to deal with the challenges before the UK.

The decision to scrap the top tax rate for people earning more than £150,000 per year was announced during the mini-budget on 23 September. For the highest earners, this would have brought down the rate from 45% to 40%. The Chancellor had argued that higher taxes reduce the incentives to work. 

However, the move received a lot of hostility from economists and even the MPs. Analysts have also downgraded the economic forecasts for the next year in the wake of the mini-budget. According to a report by the Financial Times, many analysts think that the fiscal package has aggravated the cost-of-living crisis by piling up the additional borrowing costs.

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Despite this, both the Chancellor and Truss had defended the move. In fact, just hours before he was to address the Conservative conference in Birmingham, Kwarteng defended the move in an interview, blaming external factors for sending the financial markets into chaos. 

Notably, the mini-budget had sparked fears of a further rise in interest rates by the Bank of England (BoE). As a result, several mortgage lenders have pulled down mortgage offers as rising interest rates will also lead to a rise in mortgage repayments. According to reports, as many as 40% of mortgage-related products were pulled from sale after the turbulence in the home loans markets.

There were projections that the BoE would raise the interest rates to as much as 6%. Following the tax rate reversal, these projections have fallen slightly to 5.5%. While this hints that homebuyers may get slightly cheaper deals now, experts believe that lenders are likely to take some time to adjust to the current market conditions before coming up with any new offers.

On Monday, government-backed lender NatWest (LON: NWG) raised the interest rates on its mortgage products. This will put most of its rates between 4% and 6%, from 3-4% earlier.

On the other hand, the pound sterling reacted positively to the U-turn, initially returning to levels before the mini-budget. It gained almost 2 cents against the US dollar to trade at nearly $1.13. However, it fell back by noon amid talks that Truss could make further concessions, leading to renewed bouts of volatility in the currency.

UK government bond yields also slipped a little after the U-turn. The yields had soared due to the mini-budget, forcing the BoE to intervene. The central bank has set aside £65bn to buy bonds as a temporary measure to reduce the pressure on pension funds and insurers. 

The move to scrap the 45p rate would have cost the government about £2 billion out of the £45 billion unfunded tax cuts announced during the mini-budget. While it was one of the key factors that led to the financial chaos, concerns about the rest of the plans remain. The reversal may have bought Kwarteng some more time, but the risks of further inflation and recession stay.