No, tax cuts won’t deliver economic growth

Elizabeth Truss – UK Parliament official portraits 2017
Photo: Chris McAndrew, CC BY 3.0 https://creativecommons.org/licenses/by/3.0, via Wikimedia Commons

I’ve been away on holiday for the last week, near Bakewell in the beautiful Peak District of Derbyshire. So I haven’t commented on the race to succeed Boris Johnson as leader of the Conservative Party – which under the UK’s unwritten constitution means the automatic assumption of the office of Prime Minister. I did watch (most of) the two televised debates. You will have to take my word for it that I was predicting that the final two would be Rishi Sunak and Liz Truss even as Penny Maudaunt was the 58% betting favourite to win the whole thing.

As I write, Ms Maudaunt may yet make it to the final two, to be decided by party members, and even Mr Sunak’s place there is not guaranteed. But let’s assume that things turn out as I predicted. Which one is likely to win overall? This is hard to predict. YouGov have made a valiant attempt as polling Conservative members, but to get their sample they are fishing in a large lake for a rare fish. Their polling suggests that Ms Truss has a comfortable lead. This fits with most commentators’ prejudices of the Tory membership, as most think they will prefer Ms Truss’s more ideological pitch – or may even be worried by Mr Sunak’s ethnicity. Actually I’m not so sure, and I expect Mr Sunak to prevail in the end.

These two candidates were always the strongest in the field of seven candidates left after Jeremy Hunt was eliminated. They have both held one of the great offices of state (indeed Ms Truss is still Foreign Secretary), and they are both well grounded in the sorts of choices governments have to make. The other candidates have come up with interesting debating points but show little evidence of actual grasp. Meanwhile both Mr Sunak and Ms Truss have come closest to putting forward coherent policy positions – and they clash. Mr Sunak has taken the continuity position, of keeping taxes and spending much as they are, and defending the various measures put forward to relieve hardship as the cost of living crisis takes hold. This makes sense as he was Chancellor of the Exchequer until very recently. This has been heavily criticised by Ms Truss. She says that the tax rises (National Insurance is going up, alongside Corporation Tax rates) will cause recession. Instead tax should be cut in the short term, to generate economic growth. Inflation should be curbed by the Bank of England – whom she suggested were in large part responsible for inflation in the first place.

Three questions are posed by this challenge. First, will tax cuts generate growth? Second, can Britain afford more public debt? And third, is the fight against inflation best left to the central bank? The first question is in fact quite complex one – and politicians of left and right often try to hide in the complexity to justify populist policies of lower taxes or higher spending.

There are a number of ways that tax cuts can stimulate growth. The most direct is by allowing people to spend more (assuming that it isn’t accompanied by public spending cuts) – which helps take up economic slack. Donald Trump’s tax cuts worked like this, at least to some extent. But there is very little sign of slack in the UK economy. Indeed this is one of the causes of the inflation crisis. Tax cuts will either fuel inflation or suck in imports (and the country is running a current account deficit). A second mechanism for tax to affect growth is by drawing in more capital – fixed or human – by improving incentives. The case for this is strongest for Corporation Tax – as this is something multinational companies factor into their choice of where in the world to invest – but there is little evidence that it is a big factor in the UK. But Corporation Tax is a very efficient tax, and low interest rates are keeping costs of investment generally low. There is in any case a big time lag between any tax cut and any change to investment behaviour – it will have little effect on whether the country avoids recession this year or next. The question of incentives for income taxes is much less clear – it is a classic essay question for first-year economics students. Lower taxes make work more rewarding increasing the incentive to do more, but also the could reduce the need to work to fund your chosen standard of living. If tax rates are very high (for example, the top rate of 83% current when I was calculating payroll deductions in 1976) the chances are that the former predominates – but the case is much harder to make at current levels. Tax cuts won’t help growth, especially in the short to medium term.

Can Britain afford to borrow more, meaning that it is easier to cut taxes without cutting spending too? The Conservatives promised not to do this in their 2019 manifesto. But Ms Truss suggests that we can get round this by classifying a chunk of debt as “Covid debt” to be paid off over a longer time frame. Mr Sunak says this is nonsense. Running a budget deficit in a country that controls its own currency isn’t necessarily a bad thing – it does not work like a household budget. If there is slack in the rest of the economy it is almost a national duty. And there is the argument that if the markets can’t stomach it, you can simply create the shortfall as money. But this can be inflationary, and there comes a point when the providers of finance insist on lending in other currencies. Britain has not been in anything like this danger zone since the early 1980s, when deficits from nationalised industries caused havoc to government finances. Inflation has made the picture more complicated, and debt levels are historically high (in part thanks to the covid crisis). But Ms Truss is probably right on this one – if you can deal with the arguments on inflation.

And here Ms Truss says the Bank of England can take more of the strain in turning the tide. Indeed she has suggested that the bank is partly to blame for the inflation crisis in the first place. In one of the debates she suggested that the Bank’s mandate should be modelled on that of the Bank of Japan. It is hard to credit this. The only way that the bank can fight inflation is to raise interest rates. This restrains growth – indeed the policy makes no distinction between restraining growth and restraining inflation – it tackles one through the other. From somebody who is suggesting that the problem is a lack of growth this is an extraordinary line to take. Further, the inflation problem has largely been brought about by problems on the supply side of the economy (oil/gas problems, Brexit, covid and a spate of early retirements in the workforce). It is hard to see how higher interest rates would have helped. It is simply a shallow attempt at blame shifting.

But none of the leadership contenders have wanted to confront the economic reality of Britain’s position. Britain’s workforce relative to its total population is shrinking due to demographic changes. Those same changes are placing public services under greater pressure, especially in health and social care. There are no soft spots on public spending – squeezing local authorities and benefits merely puts other services, especially the NHS and police, under yet more pressure. We have cut too much on defence. There is no productivity bonanza that will make public spending more affordable – or to be more precise, improvements in productivity are affecting a shrinking share of the economy, and cannot be expected to provide a get-out-of-jail-free card. All that points to higher taxes, or taking the country down the route of high inflation and currency and debt crises. By suggesting that he will only look at tax cuts once inflation has been dealt with, at least Mr Sunak has one foot on the ground. In the land of the blind, the one-eyed is king.

Funnily enough I have more sympathy with the Tory position than most on the left. Public spending (and taxes) should be subject to continual challenge. It is lazy to shrug our shoulders and suggest that nothing can be done. it is better for people to make their own choices n expenditure. There is a huge challenge in making public services more effective and accountable. But fantasy economics does not help.

4 thoughts on “No, tax cuts won’t deliver economic growth”

  1. agree that Liz Trust has no way of promoting growth through tax cuts. Employment can’t be increased further without generating still more inflation; and increasing company profitability through foregoing corporation tax increases flies in the face of the high corporate profits in recent years, and its failure to stimulate investment. The only explanation of her position is political; that there is intense pressure to help with the cost of living , and she hopes to blame the Bank of England for the extra interest rate rises her tax cuts would provoke. In economic terms, th idea that the tax take can fall rather than rise as our economy matures strikes me as one of those remnants of Thatcherism that we now need to abandon..

    1. Funnily enough, one of the bits of Thatcherism that has been abandoned is the idea of “sound” government finances. Reagan may have believed that tax cuts payed for themselves in the long run, but mrs thatcher didn’t – her focus was more on the marginal tax rates rather the total tax take. Something that has led to the current paradox of a historically high overall tax burden without historically high tax rates. Mrs thatcher certainly wanted to cut the size of the state – but the problem is simple demographics.

  2. “Reagan may have believed that tax cuts payed for themselves in the long run”

    Wasn’t he a follower of Laffer? The idea being that if you reduce the rate of taxation the amount of revenue would increase. This may work for something like the tax take on tobacco but it can’t work, at least not in the way intended, for all taxation combined. Government spends money into the economy and get it all back eventually, but minus what everyone else saves in the short term.

    So will they save less if taxation rates are reduced? Possibly, but that could be because everyone has more spending power which is inflationary/reflationary and so a disincentive to saving.

    It’s probably not what we want right now but it could be in a year or two’s time after this lot have crashed the economy!

    1. Yes, Reagan brought the Laffer curve into fashion – what George Bush Snr called “Voodoo Economics”. As some explain it, if tax rates are either 100% or 0%, then the tax take is nil. Somewhere in between there is an optimal tax rate. Gaffer assumes you are starting over this optimal rate, so that a rate cut takes you towards it. This is not complete nonsense – I think the top income tax rates prevailing when Mrs T took power may have been over the peak – so that when Howe cut them to 60% the take could have gone up. When Lawson cut it to 40% is more questionable.

      In fact, as you suggest a lot depends on the wider context of the policy change. in a recession is one thing, the middle of an inflationary boom another.

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