The pound dipped for a third consecutive day on Wednesday against a broadly stronger US dollar, as investors digested the British government's announcement of a tax hike to fund social care reforms and the National Health Service.
The government said the extra revenue will be crucial as the country recovers from the Covid-19 pandemic – and a long period of inadequate funding.
A vote on the tax proposals is due to take place and is widely expected to pass. If it does, the overall tax burden will be the highest it has been in decades.
In response, sterling was 0.1% lower at $1.3767 Wednesday morning. Against the euro, the pound dropped by a similar magnitude to 85.95 pence.
On Tuesday, sterling hit its weakest point versus the euro since late July.
From April, the tax changes would include a new 1.25% health and social care levy on earned income across England. Tax rates on shareholder dividends will also rise by the same amount.
It will begin as an increase on the existing National Insurance rate (a current tax on earnings) and become a separate tax on earned income in 2023.
The government said the money will raise almost £36bn (US$49.56bn) over the next three years.
Analysts said higher taxes could slow the economic recovery. However, for the pound, it could ease pressure on the Bank of England to begin tightening monetary policy.
Joshua Mahony, a senior market analyst at IG, said the UK’s plans to raise taxes, coupled with a gradual transition towards tighter monetary policy, serve to highlight how the focus is likely to shift towards withdrawing and paying for stimulus rather than implementing new support measures.
"This week has seen Boris Johnson provide a timely reminder that the seemingly one-way traffic of increased spending and financial support was always likely to ultimately result in higher taxes as the Treasury seeks to cut the deficit built up over the year," said Mahony.
"Despite a manifesto vow to avoid raising any major tax rate, the pandemic has arguably provided an acceptable platform to raise funds via the 1.25% National Insurance hike proposed by the government," he continued.
Meanwhile, economists at Pantheon Macroeconomics said it expected the tax hike to defer a full recovery in households' spending to the second half of next year, and as a result has revised down its forecast for year-over-year growth in GDP in 2022 to 5.2%, from 5.5%, if the tax hike is implemented in full.
"This hit won't be easily absorbed by households, given that the effective rate of income tax will be rising at the same time, due to the Chancellor's decision in the Budget to freeze the thresholds for the basic and higher rates at current levels for four years. Households also will lose out indirectly from the equivalent 1.25pp increase in the rate of NICs paid by employers.
"While some firms will absorb the tax hike, others will employ fewer workers or hike prices. As a result, we think the tax hike is big enough to defer by a further quarter, to Q3, the time when households' real spending returns fully to its pre-Covid level," Pantheon Macroeconomics said.