FRSE 2022-23 Topic 2

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The role of government
INTRODUCTION
The government has two main functions in relation to financial markets.
Managing the economy – financial markets operate most efficiently and

effectively in a well‑managed economy. Investors, lenders and borrowers
have the confidence to carry out transactions, and the markets operate
smoothly. The government is responsible for the efficient management of
the economy.
Regulation – the purpose of regulation is to ensure that appropriate

standards of ‘behaviour’ and consumer protection are upheld in order to
maintain confidence in the markets.
LEARNING OBJECTIVES
By the end of this topic, you will be able to:
describe the role of government in UK financial regulation and the economy;

and
explain the role of the EU in UK regulation and the impact of other

international standards.
THINK ...
Before we start this topic, reflect on how much you know about the
role government plays in the UK and Europe.
For instance:
What influence do you think the government has over the

UK economy and financial services? How does it assert that
influence?
What influence do you think the European Union has over the
UK economy and financial services?
© The London Institute of Banking & Finance 2022 27

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2.1 Managing the economy
In this section we will look in overview at the role of the government in
managing the UK economy.
Before we look in detail at the economy, we will consider the difference

between macroeconomics and microeconomics.
Macroeconomics relates to a nation’s economy as a whole – macroeconomic

policies and decisions are designed to affect the whole economy.
Macroeconomics attempts to measure how well an economy is performing,
what forces drive it and to project how performance can improve.
Microeconomics relates to a local economy, or individual sectors, people or

businesses. It looks at how their behaviour can influence the markets, with
particular focus on supply and demand and forces that determine price levels
in the economy.
Microeconomics in action: freeports are special areas within the UK’s borders
where different economic regulations apply, such as custom rules and taxes
(GOV.UK, 2021). Freeports are usually located around shipping ports and
airports. In 2021, the government announced the development of eight new
freeports in specific areas of the UK. Examples include East Midlands Airport
and Liverpool City Region including the Port of Liverpool. The aim is that
they will act as trade and investment hubs for global trade, help to regenerate
areas that have suffered from economic problems and create employment
opportunities. The government also remains committed to establishing at least
one Freeport in Scotland, Wales and Northern Ireland. This targeted initiative
is a good example of a microeconomic policy.
Objectives of economic policy

Governments create and carry out economic policies to achieve certain
objectives such as:
Price stability – a low and controlled rate of inflation to avoid the problems
associated with rising prices.
Low unemployment – to expand the economy so there is sufficient

demand for a high level of employment with a good standard of living.
High employment boosts tax revenues and keeps state welfare benefit
costs down. ’Full’ employment is generally thought to be a situation where
fewer than 3 per cent of the working age population are not working.
Balance of payments equilibrium – the balance of payments between

imports and exports is neither in large deficit nor large surplus.
Economic growth – sufficient to keep the output of the economy increasing

over time to give low unemployment and improving standards of living.
28 © The London Institute of Banking & Finance 2022

THE ROLE OF GOVERNMENT FSRE
2.1.1 Government current account

The current account records the UK trade in goods and services with other
countries, together with interest receipts or payments; goods are known as
visible trade and services as invisible trade. The current account balance is
the credits minus the debits. The capital account works on the same principle,
but this time looks at capital transfers – the inflow and outflow of capital. This
includes investment, grants, borrowing and so on.
Just like a personal bank account, where the credits exceed the debits, the
current account is in surplus, and where debits exceed credits the account is
in deficit; a deficit has to be covered somehow. The deficit arises because the
country spends more foreign currency to cover the costs than it receives for
its own exports. The government will use its foreign currency reserves – the
equivalent of an individual’s savings – to cover the gap. Once the reserves
have been used up, the government may have to borrow foreign currency to
fund overseas purchases. This is exactly what a prudent family would do: use
savings before borrowing to correct an overdraft.
2.1.2 The balance of payments

The balance of payments is the record of one country’s trade with the rest of
the world; in the case of the UK, it is calculated in sterling. Money coming into
the country is known as a credit; money going out is known as a debit.
A deficit can also be corrected by discouraging imports and encouraging

exports via the following means.
Increasing interest rates to encourage overseas investment – brings

foreign currency into the UK but can have a negative effect on the UK
economy. This is because higher interest rates make borrowing more
expensive and may reduce spending. It is also likely to make sterling
stronger – this makes exports more expensive and imports cheaper, which
can actually increase the deficit. In tough economic times, the government
is likely to try to reduce interest rates to encourage spending.
Imposing tariffs and import quotas – tariffs are effectively charges on

imports, making them more expensive and less attractive. Quotas are
limits on the quantity of certain goods that can be imported, with supply
and demand usually leading to higher prices. Both measures are designed
to make imported goods less attractive and encourage buyers to look at
domestic supplies. This is often referred to as ‘protectionism’ and is very
much against the principles of a free market.
Imposing exchange controls – the government limits free currency markets

by pegging (tying) the domestic currency to another currency, such as the
US dollar. This allows the government to control the relative value of the
currency and so determine how cheap or expensive its goods are.

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2.2 Fiscal policy
Fiscal policy (budgetary policy) is the process by which the government
attempts to influence the level of economic activity through government
spending, taxation and borrowing.
Local and national government spending is a major factor in the national

economy. In a perfect world, the government would raise all the money it
needs for its spending plans from taxation and payments received for services.
This is not usually a practical approach – high taxes are politically unpopular.
If government spending requirements exceed income, the alternative is to
borrow by issuing gilts and Treasury bills. The amount of borrowing is known
as the Public Sector Net Cash Requirement (PSNCR). The government will not be
keen to finance a significant amount of its spending from borrowing because
it will have to pay interest.
Although fiscal policy can also have an overall macroeconomic effect on the
level of activity in the economy, it has microeconomic effects and can be
targeted to particular areas of the economy. For example, tax incentives can be
given to manufacturing industries to boost employment in what is a declining
sector, or government grants can be given to firms that move to relatively
underdeveloped geographical areas.
2.2.1 Expansionary fiscal policy

The government attempts to stimulate the economy by cutting taxes and/
or increasing public spending, hoping that people will feel better off and
spend more. This in turn results in demand increasing, firms taking on more
employees and economic growth. However, the tax cuts will reduce government
revenues leading to increased borrowing to fund the deficit.
While expansionary policy may work, there is a danger that the economy could
overheat, resulting in increased imports and prices, which, in turn, lead to
increased inflation. Government borrowing increases the public debt that the
government must service, usually for many years.
We saw a good example of an expansionary fiscal policy in 2009, when the

government reduced VAT, announced increases in government spending and
outlined other initiatives to stimulate the economy.
REFLECT
What fiscal actions did the government take in 2020/21 in

response to the Covid-19 pandemic?
What concerns did economists express about those actions?
Answers at the end of this book.

FACTFIND
The term levelling up is described as “a moral, social and

economic programme for the whole of government” (GOV.UK,
2022).
You can read more at: assets.publishing.service.gov.uk/

government/uploads/system/uploads/attachment_data/
file/1052046/Executive_Summary.pdf.
2.2.2 Contractionary fiscal policy

During economic booms, inflation tends to rise and the government’s current
account shows a growing deficit. It may be necessary to cool things down
by taking measures to help the economy to contract. This means increased
taxation and reduced public spending, which would lessen demand by
reducing the amount of cash available for spending. This should reduce both
inflation and the current account deficit, perhaps even giving the government
a budget surplus. The Conservative–Liberal Democrat coalition government
of 2010–15 introduced an element of contractionary fiscal policy by reducing
government spending and raising some taxes, which was given the populist
label ‘austerity’, which is generally defined as difficult economic conditions
created by government measures to reduce expenditure.
The government outlines its fiscal policy in the annual Budget statement
made by the Chancellor of the Exchequer. The statement includes revenue
plans (including taxation of individuals and companies) and the government’s
planned expenditure. At least three months prior to the Budget, the government
publishes a Pre‑Budget Report that allows it to consult on specific policy
initiatives.
CHECK YOUR UNDERSTANDING
a) In the Budget, the government raised income taxes and

cancelled spending on a number of infrastructure projects.
b) The following year, a new government announced a number

of new infrastructure projects and reduced income tax
bands and rates.
Which fiscal policy was each government adopting?

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2.3 Taxation
Taxation is the government’s main source of income, but the amount by which
taxes can be increased is a political issue and may limit the options available.
Decisions on taxation form a central part of a government’s fiscal policy. For
example, reducing taxes can stimulate the economy by increasing the amount
of disposable income.
Taxes can also be used to redistribute the money in the economy. Increasing
the higher income tax rate(s) or lowering the point at which higher‑rate tax is
paid can reduce the taxation burden for the majority of taxpayers.
Tax is the responsibility of the Treasury, headed by the Chancellor of the

Exchequer, and is collected by Her Majesty’s Revenue and Customs (HMRC).
Tax allowances and rates are set out for each fiscal (tax) year in the annual
Budget, and so can vary from year to year. The tax year runs from 6 April to
5 April.
KEY TERMS
‘DIRECT’ TAX
The term used to describe taxes that are paid by an individual or business
directly to the government.
‘INDIRECT’ TAX
Levied on spending or use of a service, and is paid to HMRC by the

provider, who will charge the tax to the customer by incorporating it
into the price. Value added tax and Air Passenger Duty are examples of
indirect taxes.
In this topic you will gain a basic understanding of the five direct taxes. You
will learn about tax in Unit 2, Book 1 Advanced Financial Advice (Taxation).
As the tax specifics can change from year to year, the text will focus on the
principles rather than the rates and allowances. You are given a link after each
tax to find out the current details. The one exception is inheritance tax, where
the rates, allowances and exemptions have been frozen until 2026.
2.3.1 Income tax

Income tax is levied on income received from employment, self‑employment,
investments and renting property. UK income tax is payable by those who are
resident in the UK for tax purposes. The key features of UK income tax are as
follows:
Employers deduct any tax due on employment income and pay it to HMRC
on their employees’ behalf.

Self-employed people must report their trading profit to HMRC and pay any
tax due through a process called self-assessment.
The individual is responsible for reporting income from savings interest,

share dividends and property rent to HMRC and paying the appropriate tax.
The rate of tax may be different from that levied on income, as set out in
the Budget.
Each individual has a ‘personal allowance’, which is an amount that can be

received before tax is payable. The government sets a standard personal
allowance for everyone, although an individual’s allowance could be higher
or lower depending on their circumstances. Income above the personal
allowance is subject to income tax.
Tax charged is based on marginal bands (or slabs) of income. One rate is
charged on the first band of income above the personal allowance and a
higher rate on the next band. There may be further higher rate bands in
some years – the number of bands and the rate for each band is set in the
annual Budget.
FACTFIND
You can find the current income tax allowances, bands and
rates at: https://www.gov.uk/income-tax-rates.
2.3.2 National Insurance contribution (NIC)

NIC is an additional tax on employment or self-employment income. Originally
it was levied to provide certain state benefits, such as state pensions, but in
recent years has become a more general tax to fund government spending.
However, eligibility for many state benefits is dependent on making NI
contributions. The key features of NIC are as follows:
NIC is paid on earned income only – it is not paid on investment and rental
income.
Employees pay Class 1 NIC, which is calculated using bands of income.

No NIC is charged on the first band of income up to a figure called the
‘primary threshold’. Employees pay a standard rate on the next band up to
the ‘upper earnings limit’ (UEL), and a much lower rate on income above
the upper earning limit.
Employers pay Class 1 NIC in the same way as employees, but the standard
rate applies to all income above the primary threshold.
The self-employed pay Class 2 and Class 4 NICs. Class 2 is paid at a weekly
flat rate if the individual earns more than the ‘small profits threshold’, and

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Class 3 is paid as a percentage of profits between the ‘lower profits limit’
and the ‘upper profits limit’ (the same as the Class 1 primary threshold and
upper earnings limit). Profits above the upper profits limit are charged at a
lower rate, in the same way as Class 1 NICs.
FACTFIND
You can find the latest NIC bands and rates at: https://www.
gov.uk/topic/personal-tax/national-insurance.
2.3.3 Capital gains tax (CGT)

Capital gains tax (CGT) is payable on gains (profits) made by UK tax residents
on the disposal of certain assets, including shares, most investment products
and property other than the owner’s home. The key features of CGT are as
follows:
Disposal is defined as sale, gifting or assignment for money’s worth, which

means signing over ownership of the asset in exchange for money or
something of value.
Certain assets are exempt from CGT. Examples include a person’s main
residence (known as the principal private residence), gilts and corporate
bonds, motor vehicles kept for normal use and chattels, which are personal
possessions valued below £6,000.
The ‘annual exemption’ allows an individual to make a certain level of gains

in a tax year without paying CGT. The amount of the exemption is set each
year in the Budget.
There are various other exemptions and allowances that may apply to
individuals, depending on their specific circumstances.
FACTFIND
You can find the latest CGT exemptions, allowances and rates
at: https://www.gov.uk/capital-gains-tax.
2.3.4 Inheritance tax (IHT)

Inheritance tax is payable on the value of an individual’s estate when they die.
It can also arise when gifts to certain trusts are made during an individual’s
lifetime. The key features of IHT are as follows:

The estate can best be described as all of the individual’s possessions less
their debts and other liabilities. In the case of jointly owned assets, only
the deceased’s share of the asset would pass into their estate.
There is a nil-rate band of £325,000, below which no IHT is charged. IHT

is then levied at the rate of 40 per cent on the value of the estate above
the nil-rate band. There is also a residence nil-rate band when a property
forms part of the estate, calculated as the lower of £175,000 or the value of
the share of the property. So, an individual leaving a property could have a
potential total of £500,000 before IHT applies.
If an individual makes gifts (transfers) over and above any exemptions

during their lifetime, the gift will remain in their estate for seven years
from the date it was made. The nil-rate band will be reduced by the amount
of the gift, and if the gift is more than the nil-rate band there will be tax
to pay on the excess if the donor dies during the seven years. If the donor
survives for seven years, the gift is exempt and out of the estate – the nil-
rate band is restored in full and the excess is not taxable. This gives rise
to the term ‘potentially exempt transfer’ (PET). If an individual makes a
gift to most types of trust during their lifetime, there will be an immediate
inheritance tax charge on the amount above the nil-rate band, equal to half
the standard rate. If the donor survives for seven years no further tax will
be payable, but if they die within that period a further amount could be
payable.
Assets passing between spouses or civil partners (but not other

arrangements) on death are exempt from IHT and do not use up the nil-rate
band.
A spouse or civil partner can ‘inherit’ their partner’s unused nil-rate band
and residence nil-rate band.
The annual gift exemption enables an individual to gift up to £3,000

during a tax year without it being included in their estate. There are other
exemptions and allowances that may also apply.
FACTFIND
You can find the latest IHT exemptions, allowances and rates
at: https://www.gov.uk/inheritance-tax.
2.3.5 Corporation tax

Limited companies pay corporation tax on their profits. It is also payable by
clubs, societies and associations, trade associations and housing associations,
and co‑operatives. However, it is not paid by either conventional business

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partnerships or limited liability partnerships or by self‑employed individuals:
these are all subject to income tax.
Companies are taxed on profits arising in a given accounting period, usually

their financial year. Companies resident in the UK pay corporation tax on their
worldwide profits, whereas companies resident elsewhere pay only on their
UK-based business profits.
For companies with profits up to a set threshold, corporation tax is usually

due nine months after the end of the relevant accounting period. Corporation
tax is due in quarterly instalments beginning approximately halfway through
the accounting period for those with profits over the threshold.
FACTFIND
You can find the latest on corporation tax rates and reliefs at:
https://www.gov.uk/corporation-tax.
2.4 Monetary policy

Monetary policy is the combination of actions taken by a government that
affects the supply and price of money. Nowadays monetary policy refers
mainly to interest rate policy, and it is the responsibility of the central bank.
If banks are short of money, they borrow from the central bank, which charges
its own special rate which, as a result, will affect rates in the rest of the
economy. For example, if it increases the rate, banks pay more for borrowing
and pass the increase on to their customers by raising the interest rates on
their own lending.
The Bank of England (BoE), as the UK’s central bank, operates in the money
markets to provide liquidity for the system, to support its official interest rate
and also to act as lender of last resort when necessary.
2.4.1 UK interest and inflation rates

The Bank of England’s Monetary Policy Committee (MPC) is responsible for
setting the rate of interest at which the Bank deals with the short‑term money
markets; this is known as the Bank rate and is the rate that determines all the
other interest rates in the system.
A certain level of inflation is regarded as good for an economy; although

counter-intuitive, zero inflation would not be healthy. The government has set
a target inflation rate of 2 per cent, measured by the Consumer Prices Index
(CPI), and it is the MPC’s responsibility to ensure the target is met.

Monetary Policy Committee (MPC) and interest rates

The Monetary Policy Committee (MPC) is made up of nine members. Each
member of the MPC has expertise in the field of economics and monetary
policy. The MPC meets eight times a year to decide whether to increase or
decrease the Bank rate or to leave it unchanged. If inflation is more than
1 per cent above or below target, the governor of the Bank must write to the
Chancellor of the Exchequer, explaining the reason why and what action will
be taken to rectify the situation.
If the MPC believes that inflation is too high then it will raise the Bank rate.
This will cause banks to raise their rates, borrowing becomes more expensive,
and savers receive a higher rate. This in turn will reduce borrowing and boost
saving. If inflation were too low, the MPC would reduce interest rates to reduce
borrowing costs, reduce savings returns and encourage increased spending.
Please refer to Topic 6 for more information on the MPC.
FACTFIND
Read the latest information on UK consumer price inflation at:

https://www.ons.gov.uk/economy/inflationandpriceindices/
bulletins/consumerpriceinflation/january2022.
Quantitative easing (QE)

In recent years, the BoE, along with other central banks, has used ‘quantitative
easing’ (QE), which is often described as the Bank printing money to increase
the money supply. It is used to stimulate business investment and general
spending to promote growth and maintain a healthy level of inflation when
demand in the economy falls. The process is as follows.
The Bank buys assets from private sector companies, such as banks,
insurance companies and pension funds. The assets are usually bonds –
particularly government bonds (gilts) that those companies had bought
previously.
New money is created to buy the assets by sending electronic credits to the
private sector firm’s bank account. In days before e‑commerce the money
would have been printed to pay for the assets – hence the popular press
description of QE as ‘printing new money’. Either way, the Bank creates
new money rather than using money already in circulation.
There are three main ways in which QE affects the economy.
1) When the BoE buys assets, their price increases. An increase in the price
of a bond or gilt reduces the yield, as we saw earlier. A reduction in yield

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means that investors will consider switching into other assets such as
shares and corporate bonds to increase their return. This pushes up
the price and reduces the yield, and the effect of the overall reduction
in yields across assets is to reduce interest rates, leading to lower
borrowing costs for individuals and businesses. It will also lead to a
‘feel‑good’ effect for those investors who already hold shares and bonds
because their investment will have risen in value. In theory this should
all result in a general increase in spending, which will stimulate the
economy.
2) When the Bank buys corporate bonds, conditions in the capital markets
should improve, making it easier for firms to raise money to invest in
the business.
3) The new money goes into financial institutions’ bank accounts and
creates more money for them to lend.
While QE is sound in theory, unless the BoE is both skilful and to an extent
lucky, QE can lead to much higher rises in inflation than planned. This has the
knock‑on effect of increasing living costs, and together with poor returns from
deposits may reduce the amount of disposable income available to boost the
economy. In addition, while low interest rates are good for borrowers, they
have a negative effect on savers, particularly those who rely on their savings
to supplement their income.
2.4.2 The money supply

The money supply is an economic factor closely linked to other variables such
as inflation and interest rates. It is important to measure the size of the money
supply and also the speed of its growth.
Money is used as a medium of exchange, and the amount of money in

circulation must be related to the value of the goods and services that form
the basis of transactions. If the money supply exceeds the real value of goods
and services, inflation happens. So, the money supply should increase only if
the volume of goods and services also increases.
This close relationship between the money supply and the rate of inflation
makes it necessary for a country to measure the amount of money in circulation
so that it can control the growth of the money supply and indirectly influence
the rate of inflation.
The Bank of England needs to ensure there is enough money to enable all of
the required transactions to take place but it also needs to stop the money
supply from growing too fast and causing increased inflation.

KEY TERMS
M0 AND M4
Before we look in more detail, we need to understand two key measures

used by the Bank:
M0, known as narrow money, measures the cash base in the UK. It
comprises the notes and coins in circulation and the operational balances
of banks held at the Bank of England. Ninety‑nine per cent of M0 is held
in notes and coins.
M4, known as broad money, measures bank and building society deposits,
and new money created by loans and overdrafts.
Since credit creation results in new money, the Bank is interested in the amount
of bank and building society lending, and it publishes figures for what it calls
M4 lending. The Bank can manipulate interest rates to control the amount of
new credit being created.
In its monthly interest rate decision, the Monetary Policy Committee considers
the performance of various economic indicators; among these are the money
supply and its growth rate and the growth of M4 lending.
Monetary policy has a macroeconomic effect, as it acts on the economy as a

whole, currently through changes in the general level of interest rates and the
money supply.
In practice, however, fiscal policy and monetary policy are not applied in
isolation but are closely linked, and governments generally use a combination
of the two.
2.5 Inflation
Inflation is the term used for general increases in the price of goods and
services over a period. If an article cost £10 today and £11 in a year’s time, it
would have been subject to inflation of 10 per cent over the year.
Inflation is often described as a reduction in the buying power of money. For

example, if inflation ran at 5 per cent over a year, an item costing £100 at the
start of the year would cost £105 by the end of the year. This means that the
original £100 would have been reduced to just over 95 per cent of its original
buying power. In this situation, the investor would aim to achieve a rate of
growth that exceeds the rate of inflation in order to protect the ‘value’ of their
money.

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A moderate rate of inflation, perhaps of between 2 per cent and 3 per cent, is
seen as desirable for a healthy economy.
KEY TERMS
DISINFLATION
A fall in the rate of inflation: prices are rising less quickly than they
were. For example, inflation drops from 4 per cent to 3 per cent.
DEFLATION
A general fall in the price of goods and services: a negative inflation rate
of below zero per cent. For example, the cost of a selection of items falls
from £10 to £9.
An economy suffering from inflation shows several symptoms:
the prices of goods and services are rising;
people’s incomes are rising; and
the money supply is rising.
As this process happens, the value and purchasing power of money falls, so
that the amount of real goods and services that can be bought with £1 reduces
over time.
There are a number of indices designed to enable the government to keep

track of inflation.
Consumer Prices Index (CPI) – an index based on a ‘basket of goods and

services’ selected to reflect the average household’s expenditure. The CPI
is the official government measure for inflation targets, and is also used as
the measure for uplifting state benefits. The rate of the CPI will increase or
decrease in line with changes in the prices of the goods and services in the
‘basket’, which do not include mortgage and housing costs.
Retail Prices Index (RPI) – the principle of the RPI is similar to the CPI,
but some of the goods and services, and their weightings, are different;
it also includes mortgage and housing costs. The RPI has been in use for
many years and, although no longer the government’s official measure of
inflation, it is still widely used.
Average Weekly Earnings (AWE) – measures the rate of change in short‑term

earnings growth. The AWE will generally increase more quickly than the RPI
because wages tend to rise above inflation. In times of very high inflation,
however, wages (AWE) may not keep up with the RPI.

The RPI and CPI are calculated each month, using 180,000 or more price quotes
on 680 products sourced from 20,000 shops, service providers and internet
outlets. The contents of the ‘basket’ are updated each year to reflect current
spending patterns.
The Bank of England can control inflation to some extent. It can reduce inflation
by increasing interest rates, which will reduce the amount of disposable
income available to spend. Reduced spending will lead to lower prices.
Lowering interest rates, however, can increase inflation. This will increase the
amount of disposable income and boost spending. Using interest rates can be
a crude tool because the effect will not be felt for some months.
2.6 Interest rates

Interest rates are an integral part of monetary policy, although responsibility
is delegated to the Monetary Policy Committee. Interest rates are the primary
tool used to keep inflation stable and within government targets.
There are different types of interest rates such as nominal interest rates and
real interest rates.
Nominal interest rate

The nominal interest rate is the rate actually paid or charged – 5 per cent paid
on a savings account simply means that £5 is paid per annum for every £100
deposited. However, inflation will reduce the value of any interest paid in real
terms.
Real interest rate

The ‘real’ interest rate is the rate of return on an investment after adjusting
for inflation. An approximate rate can be calculated by deducting the rate of
inflation from the nominal interest rate. For example, a nominal interest rate
of 5 per cent less inflation of 3 per cent gives an approximate real interest rate
of 2 per cent.
2.7 State benefits

The government has an important role in providing a safety net for those
who, for a variety of reasons, do not have sufficient income to maintain an
acceptable minimum standard of living. The state benefit system is in place to
provide practical help and financial support for those people.
The benefits system is complex and wide ranging. In this section, you will
learn the key features of the main benefits. You will learn more about state
benefits in Unit 2, Book 2 Advanced Financial Advice (Protection).

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KEY LEARNING POINT
Means tested benefits
This is where eligibility to receive the benefit depends on a

person’s amount of income and capital.
Some state benefits are National Insurance contribution (NIC)

dependent, which means the claimant must have paid NICs for
a specified minimum period.
Other benefits are means tested. In most cases, no benefit is

payable if the claimant has more than £16,000 capital (savings
and investments), and capital between £6,000 and £16,000
will affect the amount payable.
State bereavement benefits

State benefits may be payable to a spouse or civil partner if their partner
dies, subject to meeting certain criteria. Survivors under state pension age can
receive benefits in the form of a modest lump sum and a monthly payment for
18 months, with a higher income paid to those with children.
Sickness and disability benefits

Certain state benefits are available for those who are unable to work for
medical reasons, and those who suffer from medical conditions which mean
that they require financial assistance.
Statutory Sick Pay (SSP)

SSP is paid at a fixed rate by employers to employees who are off work due to
sickness or disability for four days or longer, and have met certain eligibility
criteria relating to earnings and NICs. SSP is the employer’s statutory obligation
and is payable for up to 28 weeks. Many continue to pay a higher amount,
such as the employee’s basic salary, for a specified period; SSP would form
part of that payment.
Employment and Support Allowance (ESA)

ESA is available to those under state pension age who are self‑employed or
unemployed and suffering from an illness or disability that prevents them
from working. It is also available to employees whose SSP has ended. The
benefit is NIC dependent.

Attendance Allowance
Attendance Allowance is a tax‑free benefit for people aged 65 or above
needing help with personal care as a result of sickness or disability. It is not
means‑tested and it does not depend on having paid NICs. There are two levels
of benefit: a lower rate for people who need help with personal care by day or
by night, and a higher rate for those who need help both by day and by night.
Personal Independence Payment (PIP)

PIP is a tax‑free benefit for people who need help with personal care and/or
need help getting around. It can only be received by people whose disability
claim began before age 65 but, once granted, it can continue beyond age 65.
The benefit is not NIC dependent or means tested.
Carer’s Allowance
Carer’s Allowance is a benefit paid to people who are caring for a disabled
person for at least 35 hours a week. The carer must be aged 16 or over and
earning less than a certain amount a week. The benefit is a flat‑rate payment,
with possible additions if the carer has a partner or dependent children.
Carer’s Allowance is not NIC dependent or means tested, but is only available
if the person being cared for receives certain disability benefits.
Maternity/Paternity Payments
Statutory Maternity Pay (SMP) is a statutory weekly, taxable payment from
the employer to a pregnant employee for a total of 39 weeks during their
maternity leave. They must meet certain service and pay criteria.
Maternity Allowance is available to some pregnant women who are not able to
claim SMP. These include those who are self‑employed or who have recently
changed jobs. Maternity Allowance is paid for a maximum of 39 weeks by the
Department for Work and Pensions (DWP), not the employer, at a lower rate
than SMP but, unlike SMP, it is not taxable. Maternity Allowance is not a benefit
available to all women who become pregnant, whether or not they have been
working. There are restrictions on who can claim.
Statutory Paternity Pay (SPP)

SPP is paid at the same flat rate as SMP for one or two complete weeks. It is
available to the partner of the child’s biological mother, or to the adoptive
parent of an adopted child.
Statutory Shared Parental Pay

Statutory Shared Parental Pay allows a couple to allocate the equivalent of 37
weeks’ SMP entitlement between them (the father is already entitled to two
weeks’ SPP) as they wish, providing both partners meet certain income criteria.

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2
2.8 State benefits for the unemployed
Jobseeker’s Allowance (JSA)
JSA is a taxable benefit for people aged 18 or over who are unemployed or
working less than 16 hours a week, and are actively seeking work. JSA is NIC
dependent. It is paid at a fixed rate for those aged 25 or over, irrespective
of savings or partner’s earnings, but no additional benefits are paid for
dependants. A lower rate is paid to those under the age of 25.
Universal Credit (UC)

UC is a means-tested benefit for working age people on a low income. Introduced
in 2013, it replaced six previous means-tested benefits for those making new
claims. Referred to as ‘legacy’ benefits, they include Income Based Jobseeker’s
Allowance, Income-related Employment and Support Allowance, Income
Support and tax credits. The introduction of UC was ‘rolled-out’ (phased) over
a number of years for those in receipt of a legacy benefit, with all moving to
UC by 2024. In the meantime, they will still receive the previous benefit until
they move to UC or their circumstances change.
A major principle of the scheme is that, in order to receive financial support,

unemployed claimants must make a commitment to look for work, subject to
any personal circumstances that might make this difficult. Those who fail to
make this commitment may be subject to penalties, including reduction or
withdrawal of the benefit. Those who refuse to make a commitment will not
receive the benefit. Carers, single parents with children under the age of one,
and those with limited capacity or capability for work, will not be expected to
work or prepare for work.
Benefit cap
The benefit cap limits the total amount of state benefit an individual or family
can receive. It applies to those between 16 and state pension age. If their
benefits are above the cap, their Universal Credit or Housing Benefit payments
are reduced to bring their benefits within it. Benefits subject to the cap include:
Universal Credit;
Bereavement Allowance;
Child Benefit;
Child Tax Credit;
Employment and Support Allowance;
Housing Benefit;
Incapacity Benefit;
Income Support;

Jobseeker’s Allowance;
Maternity Allowance;
Severe Disablement Allowance;
Widowed Parent’s Allowance (or Widowed Mother’s Allowance or Widow’s

Pension before 9 April 2001).
2.9 State pensions

The government introduced pension provision in 1908, but state pensions
first appeared in something like their current form after the Second World War,
when the National Insurance Act 1946 provided for pensions to be payable to
employed people on retirement at age 65 (men) or 60 (women). By 2018, state
pension age was equalised at 65 for both men and women, and by 2020 the age
was increased to 66 for everyone. The state pension age (SPA) will be increased
to 67 between 2026 and 2028, and to 68 by 2046, reflecting increasing life
expectancy and the overall cost of providing the state pension. The basic state
pension is set at about one quarter of the national average earnings level, and
on its own ensures little more than subsistence living.
In order to qualify for the basic state pension, an individual must have paid
NICs for a specified number of years, with the final pension proportional to
NICs paid. The way in which the state pension was built up changed from
6 April 2016, and it will now be possible for an individual to receive benefits
built up under either or both systems.
Pre 6 April 2016

Those reaching state pension age before 6 April 2016 received a basic state
pension and those who were employed, but not self-employed, could earn top-
up payments earned under one or more of three additional state schemes. The
maximum pension was based on 30 years’ NIC payments and the minimum
based on one year’s NIC payments.
Those reaching state pension age before 6 April 2016 will continue to receive
benefits earned under the pre-2016 arrangements. In the case of married
couples or civil partners, both will receive their own entitlement to the state
pension. If one partner’s entitlement to the basic pension is less than 60 per
cent of the full amount, they will receive a top up to their pension to bring it
to 60 per cent.
On or after 6 April 2016

Those reaching state pension age from 6 April 2016 receive a new state
pension, with the maximum based on 35 years’ of NICs and a minimum of
ten years’ NICs required to receive any pension. The new state pension is

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2
commonly referred to as a ‘flat rate, single-tier’ pension, because no top-up
benefits can be built up.
Although it is not possible to build up additional benefits from top-up schemes

after April 2016, many people retiring from April 2016 will have accrued
additional benefits until that date. These individuals will receive the greater
of their entitlement on the new state pension and their entitlement under the
pre-2016 basis.
It is anticipated that it will be around 2066 until all new retirees will receive
only the ‘new state’ pension.
STATE PENSION EXAMPLES
Keira has been employed all her working life, and she will
qualify for a full state pension in a few years’ time; she has
also accumulated top-up benefits. She qualifies for the new
state pension but, because her pension will be based on the
basic state pension plus the top-up and is more than the new
state pension, she will receive the higher amount.
Danny is self‑employed and reaches state pension age in five

years’ time. He will only receive the new state pension because
he is self-employed and has no entitlement to additional state
pensions.
Pension Credit
Pension Credit is a means tested benefit designed to ensure that those of state
pension age have a minimum income. It is available to men born before 6 April
1951 and women born before 6 April 1953, and is not NIC dependent.
Pension Credit guarantees a minimum income broadly equivalent to the flat

rate state pension, and a higher amount for couples, and will top up income
to the guaranteed amount. The additional couple’s amount is only payable if
both partners meet the age requirement.
Savings or capital above £10,000 is converted to a notional income and added

to actual income to determine if, and how much, Pension Credit is payable.
2.10 Regulation
Regulation of the financial services industry is ultimately the responsibility of
the government, which is responsible for setting in place a regulatory regime
that protects consumers but at the same time promotes competition and

growth in the financial sector. Broadly speaking, regulation in the UK is a four-

tier process:
1) Acts of Parliament that set out what can and cannot be done. In relation
to Acts of Parliament, the effects of the laws are often achieved through
subsidiary legislation – known as statutory instruments – which are made
pursuant to the Act. Examples of legislation that directly affect the industry
are the Financial Services and Markets Act 2000, the Banking Act 1987 and
the Building Societies Act 1997.
2) Regulatory bodies that monitor the regulations and issue rules to make
legislation work in practice. These are the Prudential Regulation Authority
(PRA) and the Financial Policy Committee (FPC), both of which are part of
the Bank of England, and the Financial Conduct Authority (FCA).
3) Policies and practices of the financial institutions themselves and the

internal departments that ensure they operate legally and competently.
4) Arbitration schemes to which consumers’ complaints can be referred. For

most cases, this is the Financial Ombudsman Service.
The current regulatory regime is described in more detail in Topic 6 and

Topic 7.
2.11 The impact of the EU on UK regulation

In spite of the UK retaining its own currency and control over its own monetary
policy during membership of the EU, the UK was required to implement EU
directives and regulations into UK law. As a result, the financial services industry
was hugely influenced by the EU’s policies and laws, with large sections of
the UK’s financial regulatory regime for individuals and for companies being
determined by European laws. This includes regulation relating to banking,
investment, life assurance, general insurance, operating as a financial adviser,
compensation for losses, money laundering, data protection and many other
areas.
EU legislation takes two forms:
Regulations are established by Acts of the EU parliament and must be

implemented directly into member states’ law.
Directives are issued by the EU parliament, and they outline an objective

that member states are required to achieve rather than a specific law. The
individual states must then decide how best to meet the objective through
their own legislation.
2.11.1 Brexit and impacts on UK regulation

Brexit is the name given to the United Kingdom’s departure from the
European Union. When the UK left the EU on 31 January 2020, a transition (or

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2
implementation) period began, running until 31 December 2020, during which
EU rules and regulation still applied while negotiations over details of trade
agreements were held.
The aim of the UK’s European Union (Withdrawal) Act 2018 as amended by
the European Union (Withdrawal Agreement) Act 2020 was to retain EU law
(implemented through directives and regulations) in the UK as it was before
the UK left the EU. The Act came into force on 31 January 2020, and included
powers for the government to correct ‘deficiencies’ in the EU law that would
cause problems immediately after the UK left the EU. Any major changes to
implemented EU law require the full parliamentary processes, which could be
achieved over time.
The PRA and the FCA were delegated powers to amend rules and technical
standards to correct any deficiencies in the financial services sector. The
process of amending legislation applied only to those regulations affected by
Brexit and is referred to as ‘onshoring’.
2.11.2 Onshoring and temporary transitional power (TTP)

To recognise that firms would need time to adapt their processes to meet
the new onshored requirements, certain regulators, including the FCA, were
given powers to make transitional provisions on a temporary basis. Known
as temporary transitional power (TTP), firms had until midnight on 31 March
2022 to make the necessary changes to comply with the new onshored regime.
During the transitional period, firms could choose to comply with the pre-
Brexit rules or meet the onshored requirements.
Equivalence
The UK was bound by EU legislation while it was still an EU member, and UK
financial firms were able to operate in the EU without requiring authorisation
in each state. This was referred to as ‘passporting’, whereby a firm authorised
in one state did not require separate authorisation to operate elsewhere in the
EU. Once the UK left the EU, passporting was no longer available, which means
UK firms must either stop operating in the EU or gain authorisation in the
states where it wishes to operate.
Equivalence is a situation where the authorities in one country allow firms in

another country to access their markets, providing there is agreement that
the regulatory standards for the specific activity in both countries are broadly
equivalent. Equivalence does not apply to all aspects of financial services,
in particular core banking, accepting deposits and retail investments, which
means it does not provide the full access given by passporting.
In March 2021, the UK and EU signed a Memorandum of Understanding,

agreeing to continue talks on financial services to create a framework for
voluntary regulatory co-operation.

The UK has agreed equivalence arrangements with a number of non-EU

countries, and is seeking further agreements.
2.12 Global co-operation

The UK engages with a number of global regulators and supervisory counterparts
in other countries. These include:
The Financial Stability Board (FSB). The “FSB promotes international

financial stability; it does so by co-ordinating national financial authorities
and international standard-setting bodies as they work toward developing
strong regulatory, supervisory and other financial sector policies. It fosters
a level playing field by encouraging coherent implementation of these
policies across sectors and jurisdiction” (FSB, 2020).
The International Organization of Securities Commissions (IOSCO). The

IOSCO is the international body that develops, implements and promotes
adherence to internationally recognised standards for securities regulation.
It works with the G20 and the Financial Stability Board (FSB) on global
regulatory reform.
The International Association of Insurance Supervisors (IAIS). The

IAIS is “a voluntary membership organization of insurance supervisors
and regulators from more than 200 jurisdictions, constituting 97% of
the world’s insurance premiums. It is the international standard-setting
body responsible for developing and assisting in the implementation of
principles, standards and other supporting material for the supervision of
the insurance sector” (IAIS, 2022).
Financial Action Task Force (FATF). The FATF describes itself as the
“global money laundering and terrorist financing watchdog” (FATF, 2022).
It is an inter-governmental body that sets international standards designed
to prevent terrorist financing.
The Organisation for Economic Co-operation and Development (OECD) is

an international organisation that works with governments, policy makers
and people to develop international standards and solutions to a range of
social, economic and environmental Issues, aiming to achieve prosperity,
equality, opportunity and wellbeing for all.
The International Monetary Fund (IMF) is a global organisation with 190

member countries. Its aims include the promotion of international financial
stability and monetary co-operation, the facilitation of international trade,
the promotion of employment and sustainable economic growth, and the
reduction of global poverty (IMF, 2022).

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2
Conclusion
The government uses fiscal and monetary policies to manage the UK economy,
which comprise taxing and spending, interest rates and money supply. The
Monetary Policy Committee plays an important role in controlling inflation,
and is responsible for setting the bank interest rate.
The UK government is ultimately responsible for financial services regulation,

with the PRA and FCA having delegated responsibility for the supervision of
the industry. Much of the UK’s financial services legislation has developed
from EU regulations and directives, which have been implemented into UK
law. The UK’s withdrawal from the EU has resulted in an ongoing process of
adapting that legislation to suit UK needs, and maintain continued access to
EU markets for UK financial firms.
THINK AGAIN . . .
Now that you have completed this topic, how has your knowledge
and understanding improved?
For instance, can you:
list the four main objectives of government economic policy?
explain what is meant by the terms fiscal and monetary policy?
summarise the key features of the four main direct taxes?
describe the main state benefits?
explain the four tiers of the UK regulatory system and the

impact of the EU on UK regulation?
References
FATF (2022) Who we are [online]. Available at: www.fatf-gafi.org/about/
Financial Stability Board (2020) Mandate of the FSB [online]. Available at: fsb.org/about/
GOV.UK (2021) Freeports [online]. Available at: gov.uk/guidance/freeports
IAIS (2022) Welcome to the website of the IAIS [online]. Available at: iaisweb.org/home
IMF (2022) About the IMF [online]. Available at: imf.org/en/About

Test your knowledge
?
Use these questions to assess your learning for Topic 2. Review the
text if necessary.
Answers can be found at the end of this book.
1) What are the two main functions of the government in financial

markets?
2) What are the main economic objectives of modern government?
3) What is fiscal policy? What are three main components?
4) The government has decided to discourage imports and

encourage exports. What effect would it hope this would have
on the country’s balance of payments?
5) What is the key component of monetary policy?
6) What is the MPC inflation target? What happens if the target is

missed?
7) What is the difference between disinflation and deflation?
8) What is the approximate real rate of return if the nominal

interest rate is 4.5 per cent and inflation is 3 per cent?
9) Briefly describe the four tiers of the UK regulatory system.
10) In a regulatory context, what is meant by the term ‘onshoring’?

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TOPIC

The government has two main functions in relation to financial markets.

 Managing the economy – financial markets operate most efficiently and

 Regulation – the purpose of regulation is to ensure that appropriate

By the end of this topic, you will be able to:

 describe the role of government in UK financial regulation and the economy;

 explain the role of the EU in UK regulation and the impact of other

 What influence do you think the government has over the

© The London Institute of Banking & Finance 2022 27

Before we look in detail at the economy, we will consider the difference

Macroeconomics relates to a nation’s economy as a whole – macroeconomic

Microeconomics relates to a local economy, or individual sectors, people or

Objectives of economic policy

 Low unemployment – to expand the economy so there is sufficient

 Balance of payments equilibrium – the balance of payments between

 Economic growth – sufficient to keep the output of the economy increasing

28 © The London Institute of Banking & Finance 2022

2.1.1 Government current account

2.1.2 The balance of payments

A deficit can also be corrected by discouraging imports and encouraging

 Increasing interest rates to encourage overseas investment – brings

 Imposing tariffs and import quotas – tariffs are effectively charges on

 Imposing exchange controls – the government limits free currency markets

© The London Institute of Banking & Finance 2022 29

Local and national government spending is a major factor in the national

2.2.1 Expansionary fiscal policy

We saw a good example of an expansionary fiscal policy in 2009, when the

What fiscal actions did the government take in 2020/21 in

What concerns did economists express about those actions?

Answers at the end of this book.

30 © The London Institute of Banking & Finance 2022

The term levelling up is described as “a moral, social and

You can read more at: assets.publishing.service.gov.uk/

2.2.2 Contractionary fiscal policy

CHECK YOUR UNDERSTANDING

a) In the Budget, the government raised income taxes and

b) The following year, a new government announced a number

Which fiscal policy was each government adopting?

© The London Institute of Banking & Finance 2022 31

Tax is the responsibility of the Treasury, headed by the Chancellor of the

Levied on spending or use of a service, and is paid to HMRC by the

2.3.1 Income tax

32 © The London Institute of Banking & Finance 2022

 The individual is responsible for reporting income from savings interest,

 Each individual has a ‘personal allowance’, which is an amount that can be

2.3.2 National Insurance contribution (NIC)

 Employees pay Class 1 NIC, which is calculated using bands of income.

© The London Institute of Banking & Finance 2022 33

2.3.3 Capital gains tax (CGT)

 Disposal is defined as sale, gifting or assignment for money’s worth, which

 The ‘annual exemption’ allows an individual to make a certain level of gains

2.3.4 Inheritance tax (IHT)

34 © The London Institute of Banking & Finance 2022

 There is a nil-rate band of £325,000, below which no IHT is charged. IHT

 If an individual makes gifts (transfers) over and above any exemptions

 Assets passing between spouses or civil partners (but not other

 The annual gift exemption enables an individual to gift up to £3,000

2.3.5 Corporation tax

© The London Institute of Banking & Finance 2022 35

Companies are taxed on profits arising in a given accounting period, usually

For companies with profits up to a set threshold, corporation tax is usually

2.4 Monetary policy

2.4.1 UK interest and inflation rates

Managing the economy – financial markets operate most efficiently and

Regulation – the purpose of regulation is to ensure that appropriate

describe the role of government in UK financial regulation and the economy;

explain the role of the EU in UK regulation and the impact of other

What influence do you think the government has over the

Low unemployment – to expand the economy so there is sufficient

Balance of payments equilibrium – the balance of payments between

Economic growth – sufficient to keep the output of the economy increasing

Increasing interest rates to encourage overseas investment – brings

Imposing tariffs and import quotas – tariffs are effectively charges on

Imposing exchange controls – the government limits free currency markets

The individual is responsible for reporting income from savings interest,

Each individual has a ‘personal allowance’, which is an amount that can be

Employees pay Class 1 NIC, which is calculated using bands of income.

Disposal is defined as sale, gifting or assignment for money’s worth, which

The ‘annual exemption’ allows an individual to make a certain level of gains

There is a nil-rate band of £325,000, below which no IHT is charged. IHT

If an individual makes gifts (transfers) over and above any exemptions

Assets passing between spouses or civil partners (but not other

The annual gift exemption enables an individual to gift up to £3,000

There are three main ways in which QE affects the economy.

the prices of goods and services are rising;

people’s incomes are rising; and

the money supply is rising.

Consumer Prices Index (CPI) – an index based on a ‘basket of goods and

Average Weekly Earnings (AWE) – measures the rate of change in short‑term

Child Tax Credit;

Employment and Support Allowance;

Severe Disablement Allowance;

Widowed Parent’s Allowance (or Widowed Mother’s Allowance or Widow’s

Regulations are established by Acts of the EU parliament and must be

Directives are issued by the EU parliament, and they outline an objective