One of the central arguments of Rishi Sunak’s campaign to become the next Prime Minister is that it would be irresponsible to cut taxes further until inflation is under control. Of course, there are risks here, but my view is that they are worth taking.
For a start, it is not clear that tax cuts have to be inflationary. Indeed, a recent paper from the Bank for International Settlements concluded that the inflationary effect of fiscal stimulus depends crucially on how central banks respond.
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 is largely determined by 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 might not be so 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.
What’s more, there are some ways in which tax cuts could reduce inflation, both directly (such as cuts in VAT or fuel duty), and indirectly (though much also depends on the impact on inflation expectations). Income tax cuts can increase the incentive to work, easing labour shortages and taking some of the immediate pressure off wages, while cuts in corporation tax can encourage business investment that would reduce inflation in the longer term.
Even if the overall impact on inflation is unfavourable, it is therefore likely to be small. Initial Bank of England analysis of the Government’s recent cost of living support package (costing over £15 billion) suggests that it might raise CPI inflation by (just) 0.1 percentage points. This is surely a ‘price worth paying’ to provide more help for the most vulnerable.
It would also be no bad thing 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, which would help with inflation as well.
Concerns about the debt interest bill are exaggerated too. 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.
Finally, worries about the impact of tax cuts on inflation did not prevent Rishi Sunak from pressing ahead with the large increase in the National Insurance threshold earlier this month. It is odd to hear the former Chancellor placing so much emphasis on controlling inflation, when that is the Bank of England’s job, while at the same time appearing to rule out further fiscal measures that might help get inflation down, or at least make it easier for households and businesses to cope.
In short, now is actually a good time to be cutting taxes further. The economy is fragile and will need some more support when energy bills jump again in the autumn. Indeed, higher inflation makes it easier to pay for tax cuts, because higher nominal incomes and prices are boosting the Treasury’s revenues (probably far more than the OBR is currently forecasting, as outlined by the CEBR here). It is right to give at least some of this unexpected windfall back to people who really need it.