Everyone is supposed to have their 15 minutes of fame. Perhaps I have just had mine, after the contenders for the Tory leadership were invited to endorse the ‘Charter for tax cuts’ that I co-wrote for Conservative Way Forward.
It was certainly pretty cool to be namechecked at the launch event on Monday both by the new Chancellor, Nadhim Zahawi, and by a strong candidate to be the next Prime Minister, Suella Braverman.
The thinking behind the piece was simple. I wanted to summarise the case for tax cuts and respond to some of the arguments against, including that we cannot afford them, or that they would be inflationary.
The timing, as it turned out, could not have been better. The changes at the top are a golden opportunity to rethink economic policy. The Government should do much more to lower the burden of taxation as part of a pro-growth strategy, including proper supply-side reforms and a return to sound money.
Other countries are facing similar economic challenges, but the UK is one of the few to be actively tightening fiscal policy in the midst of a global crisis. This is contributing to a significant increase in the burden of tax, which will soon be the heaviest since the 1940s.
Rishi Sunak recognised the need to slow the pace of consolidation and to provide more help to households. Nonetheless, the overall fiscal stance will continue to be contractionary on current plans. The tax system is also becoming more complicated, especially for businesses.
The arguments in favour of cutting taxes are therefore straightforward. It is right in principle: people should be free to decide how to spend more of their own money. Higher inflation also means many people are now paying far more in tax than they – or the Treasury – had expected.
Cutting tax is also right in practice, especially now, when the UK needs to boost growth and households need more help to deal with the cost of living. But this is not just about supporting demand. Tax cuts can also help the supply side of the economy by making work pay, and encouraging enterprise and investment.
There is still a danger that some people see tax cuts as the solution to any economic or social problem, in the same way as others might always want more public spending. The Office for Budget Responsibility (OBR) is right to warn that tough decisions will have to be made. A fiscal watchdog that does not bark would not be much use at all.
Nonetheless, there is nothing fiscally responsible about tax increases if they tip the economy into recession, saddling future generations with a weaker economy and even higher bills.
In the meantime, there is still plenty of room for a little more borrowing against any sensible fiscal rules. According to the OBR’s baseline scenario, the UK’s public debt-to-GDP ratio is actually projected to fall from around 96% now to less than 70% in the 2030s, before rising again. There is not magic number here, but anything less than 100% is fine.
Concerns about the debt interest bill are also exaggerated. In particular, the impact of higher inflation on the cost of index-linked gilts will be spread over many years, and the real interest rates on these bonds are still firmly negative.
It is not clear either that tax cuts would add much, if anything, to inflation. For a start, the overall level of inflation depends mainly on monetary policy, not fiscal policy.
What’s more, tax cuts could actually reduce inflation, both directly (such as cuts in VAT or fuel duty) and indirectly (income tax cuts might increase the incentive to work, easing labour shortages and taking some of the pressure off wages).
Even if the overall impact on inflation is unfavourable, it is therefore likely to be small. To provide some perspective here, initial Bank of England analysis suggests that the recent cost of living support package (costing well over £15 billion) might raise CPI inflation by (just) 0.1 percentage points.
It would not necessarily be a bad thing either if we did end up with looser fiscal policy and tighter monetary policy. Most economists agree that the UK has got this mix wrong. A shift in the balance here should support sterling too, which would also help with inflation.
Worries about the impact on inflation have also not prevented Rishi Sunak from cutting some taxes already, notably the large increase in the National Insurance threshold. These concerns are evidently not insurmountable.
Which tax cuts to prioritise largely depends on exactly what you are trying to achieve, whether it is a quick boost to demand, more support to lower income households or the ‘squeezed middle’, or improvements in the supply-side performance of the economy.
Everyone will have their favourites here. My own would be to cancel the planned increases in corporation tax, lower income tax by unfreezing the thresholds and bringing forward the cut in the basic rate, and do a bit more now on the cost of energy (including cutting VAT on fuel).
But regardless of exactly how it is done, the Government needs to do more to reduce the tax burden again – and the sooner the better.
This article was first published by the Spectator on 12th July 2022
3 thoughts on “Making the case for tax cuts”
“For a start, the overall level of inflation depends mainly on monetary policy, not fiscal policy.”
Really? I mean really?
Yes. Basic economics tells you that inflation is caused by too much money chasing too few goods and services. But tax cuts in themselves do not increase the stock of money in the economy. This depends on monetary policy, not fiscal policy. Tax cuts might add to inflation by increasing the velocity of circulation of money. But it is more likely that they will simply allow people to buy the same volume of goods and services as before, at the now higher prices, rather than cause prices to rise further. Wealthier households who are not cash-constrained to begin with are also more likely to save any gains from tax cuts (or additional cost of living support, including the energy bill discount), rather than spend more as a result.
There is no way to study economic forces and relations as existing separately from political forces and relations. This is not only because any particular historical example of an economic event will be bound up with politics but also because there is no economic domain outside of other domains (social, cultural, political) and because there are no economic forces except those deeply entangled with political forces.