The Chancellor should continue to let the deficit take the strain

On Wednesday (25th) the Chancellor will announce the results of a one-year Spending Review, setting departmental limits for 2021-22. This will not be a full Budget – let alone a multi-year programme of tax increases or spending cuts. But there is still a huge amount of (mostly unhelpful) speculation about what might be in it, and what’s coming next.

In part this is because the Office for Budget Responsibility will publish its latest forecasts for the economy and public finances alongside the Spending Review. These numbers are likely to be horrendous. This year’s budget deficit could easily top £400 billion, or 20% of national income (as measured by GDP). The stock of debt has already reached £2 trillion, or 100% of GDP. That’s more than £100,000 for every family in the UK.

It’s therefore understandable that many commentators think that tax hikes are inevitable – the only questions are which taxes, when, and by how much. But I’d begin by asking whether taxes have to rise at all.

The key point is that the shock to the public finances is temporary and manageable. The annual deficit will narrow again as the economy recovers from Covid. The extra debt taken on to pay for the pandemic doesn’t itself have to be repaid, because it can be rolled over by selling new government bonds (gilts) as old ones mature.

Indeed, this is what almost always happens: the OBR database shows that the last time the government ran a budget surplus was in 2000-01, since when debt has climbed by over £1,700 billion.

Of course, the government still has to pay interest on this debt. But this is currently very cheap: it costs the UK government just 0.3% a year to borrow for 10 years from the private sector, and even less when gilts are then bought by the Bank of England (which repays the interest to the Treasury, less the 0.1% it pays on the reserves issued to finance the gilt purchases).

Even if interest rates do rise soon, the long average remaining life of UK gilts (about 15 years) means that cheap borrowing is locked in for an extended period.

Above all, what matters most is the burden relative to national income, rather than the headline numbers in billions (or even trillions) of pounds. Indeed, the UK’s public debt has been far higher in the past as a share of GDP, and this ratio is still low compared to many other countries.

But suppose that more does need to be done to repair the public finances. Here, at least, most agree that there is no urgency. Even the Resolution Foundation, which has proposed tax rises of £40 billion (about £2,000 per family), has suggested waiting until ‘sometime after 2023-24’.

Even this could be too soon. Policy should focus on boosting growth and reducing the burden of debt that way – for the foreseeable future. Tax increases (or spending cuts) could simply hold back the recovery.

I would therefore wait until 2025 at the earliest. By then we will have a better idea of the long-term economic impact of the pandemic. I can see many reasons for optimism here, including the fact that unemployment has remained much lower than many feared, and the potential for productivity to be rebooted. The lifting of Brexit uncertainty (at last!) should help too.

2025 would also be after the next general election, allowing a proper debate about any ‘tough choices’ that need to be made.

In the meantime, predictions that Covid will leave a fiscal hole of £40 billion are little more than guesswork. Just to emphasise how hard it is to forecast the public finances, total new borrowing in the seven months to October was still £76.5 billion lower than estimated by the OBR just a few months earlier. (I’d mention that whenever someone insists we need to save a few billion next year on public sector pay, or foreign aid.)

What’s more, even if £40 billion is the right number, it is wrong to assume all this should come from taxes. Public spending was about 40% of GDP before the pandemic, or £900 billion. This is already more than enough to fund good public services and a strong welfare safety net.

The response to the pandemic has also underlined just how badly Whitehall spends our money. It must be possible to find some additional savings here and still have room to increase investment in infrastructure, hospitals, and schools. Just a 2% saving could reduce the deficit by £20 billion.

Calls for higher taxes on wealth or capital gains should certainly be rejected. These run the risk of ‘double taxation’ and other forms of unfairness, including retrospective taxation of pension investments and house purchases made many years ago.

The government should also ignore calls for higher taxes on businesses. This taxes are ultimately paid by all of us, as consumers and workers, but Brexit uncertainty makes it even more important that the UK remains an attractive place to invest and create jobs. If anything, the Covid tax cuts should be extended – notably the reduction in VAT on hospitality and the stamp duty holiday.

However, more could be done to ensure that income from labour and capital is taxed at similar rates, and to close loopholes which disproportionately favour the well-off. I would also favour restricting pensions tax relief to the basic rate, which could bring in at least £11 billion.

The burden of tax could also be shared more fairly by merging national insurance contribution with income tax. This would lift many low-earners out of direct tax altogether, but raise more from high-earners (including those past the state pension age). At the risk of making myself even less popular with older drivers, I’d end the freeze on fuel duty too.

Overall, I’m far from convinced that taxes will need to rise soon, or that the Chancellor should take an axe to public spending. For the remainder of this parliament the government should concentrate on helping the economy to recover from Covid, even if this means more borrowing in the meantime.

PS. since I started writing this the government has announced an additional £16.5 billion for defence, spread over four years. This is not a big deal for the economy or the public finances. Defence spending tends to provide a relatively small boost to growth (partly because of the high import content). There are also probably cheaper ways to ‘create’ 40,000 new jobs. But the additional spending could make a big difference to our defence capabilities, if well spent, and this is how it should be judged.

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