Immediate “tax cuts” are required but as part of a big policy push.

 

With the UK in the middle of choosing a new Prime Minister against a difficult economic backdrop of rising inflation, potential recession and troubling public finances, the focus of the candidates’ campaigns have increasingly been on whether there should be tax cuts now or sometime in the future.

I would advocate that the UK economy desperately needs lower taxes now. Why?

We unlike any other G7 country have raised taxes, so that combined with a substantial tightening of monetary policy our growth prospects are the worst of any country in the G7 according to the latest OECD forecast. Furthermore, as a result of the pandemic and a reluctance since of a populist government to cut back on the size of the public sector, taxes now represent the highest share of GDP in 70 years. People need to be reminded that the dynamism of an economy is impacted by a rising share of taxation –only private sector activity generates wealth. The former chancellor (one of the two remaining candidates to be PM) actually has raised taxes on National insurance contributions with a planned rise on corporation taxes from 19% to 25% (even though the US has reversed its plan to hike the rate). Such taxes will damage investment, employment and productivity, and ultimately depress growth. If we reversed these tax hikes, and paused the green levies (as recommended by the other remaining candidate) they would boost growth, raise tax revenues and ease the cost of living crisis. In any case, these tax cuts are quite small beer at some £30bn when compared with forecast errors  or in the context of a £2trn+ economy, particularly when one remembers the scale of fiscal drag with the freezing of various tax thresholds and the level of inflation which have boosted tax revenues without a matching rise in public spending. It hardly makes the advocate, a tax cut “slasher” or Laffer Curve supporter.

What of the public finances? Well thanks to the responsible policies of the previous two administrations before Brexit, this country has built up a lot of credibility in the market. Thus there is a strong case for treating the pandemic debt separately as like with War debt, which can be paid over many decades. In any case, our public debt burden at 88% of GDP compares favourably with other G7 countries, only being bettered by Germany at 71% of GDP – Canada 102%, France 113%, US 126%, Italy 151% and Japan 262%. Moreover the maturity of the debt is still very favourable at an average maturity of 14 years. Although with recent gilt sales, the gilt share owed to overseas investors has risen to 28%, this is still very manageable.

The strongest argument put forward against tax cuts has been the threat of a further boost to inflation, which on the CPI measure has already reached a 40-year high of 9.4% in June. (As an aside I warned back in my blog of February 2021 that we were set for a prolonged rise in inflation thanks to the impact of Quantitative Easing and pointed out later as a result of global supply issues that the UK and other G7 economies were set for double digit inflation without it falling back sharply in contrast to the majority of economists who thought it was transitory and had no monetary cause). It has been argued that tax cuts would raise aggregate demand and therefore increase inflationary pressures, ceteris paribus. However, if we cut taxes such as NICs and Corporation taxes, rather than say personal income taxes, they will increase aggregate supply so dampening any Keynesian demand pull inflation. Furthermore, subject to what happens in Ukraine and to wages in this county, inflation should subside in 2023 as a result of a substantial period of Quantitative tightening, notably in the US and the UK. 

Talk of a boost to aggregate supply moves me on to emphasising that tax cuts would be just one supply-side measure needed to drive the UK’s growth rate higher without raising inflation. This includes, lower and more suitable regulations post-Brexit, reform of a dysfunctional NHS, reform of a severely bloated civil service, the reining in of Trade Union power, increasing in immigration in sectors where more labour is required, and finally a comprehensive overhaul of energy policy.

So what about interest rates? Well they are headed higher than one would want thanks to the failures of the Bank of England to reverse QE earlier enough. However, despite the pain for some, interest rates should be raised to more normal levels. Low interest rates have been responsible for causing asset bubbles in property and equities, so causing intergenerational unfairness. Higher interest rates will help to take the heat out of the housing market, at last importantly reward savers a fair rate which will facilitate higher investment, and put Zombie companies under financial pressure.