The government’s choice: higher taxes or higher interest rates?

Britain’s Conservative government is approaching two years in office. Depending on how it amends the legislation on fixed-term parliaments, it will seek re-election in as little as a year and half (May 2023), or, more likely, in two to two and half years (later in 2023 or May 2024). The endgame of this parliament’s existence is now in sight. Tory thoughts turn to the question of how to secure a further term in office.

The 2019 election was fought largely on the question of “Getting Brexit done”, as the Conservatives successfully framed it. But they also set out a broader agenda: “levelling up” – tackling inequality by securing a better deal for the less well-off regions and groups rather than by punishing the better-off; improving public services – mainly the NHS and police; curbing immigration – the big dividend from Brexit; and keeping the country on the path to carbon neutrality. This is pretty popular and the government shows no sign of backing down on any of it. But with the possible exception of immigration, these aims aren’t notably different from the opposition’s. The Tories are further distinguished by putting more faith in the enterprise and initiative of private individuals and businesses, rather than a bossy government and government-sponsored mega-projects (even if Boris Johnson, the prime minister, has a weakness for the latter). To many observers this agenda looks impossible to reconcile – a question of “have your cake and eat it”, but it is not entirely vacuous. The left tends to underestimate the importance of setting the zeitgeist so that private initiative sets society on the right path.

Nevertheless the shallowness of most Conservative thinking is breathtaking. One example of this is the idea, popular in the party, of announcing a cut in income tax before the next election. The idea is that this would show the benefits of Tory stewardship of the economy, and drive a wedge between Labour and many of its potential supporters. It would also straighten up the record a bit after the party was forced to raise National Insurance, which it had promised not to do. It is a truly terrible idea. Basic Rate Income Tax, alongside VAT, is the the most broadly based tax the government raises, and it is therefore a valuable economic tool. And yet raising it has become a politically toxic idea, ever since Labour under Tony Blair and Gordon Brown promised not to do so in the mid-1990s. They preferred to raise National Insurance instead, even though this tax is narrower, and the employer-levied version adds friction to job creation. One of Mr Brown’s biggest mistakes was cutting the tax to 20% in 2007. The Great Financial Crisis soon after showed how much the government was relying on volatile capital taxes, and the income tax cut contributed to a dire budget deficit that panicked the subsequent coalition government into drastic spending cuts. Cutting the Basic Rate adds a level of instability to the country’s economic management.

Still, that line of argument is unlikely to appeal to Tory MPs, who seem to have a blind faith in muddling through. The bigger problem for the party is that supply and demand is out of kilter in the UK economy, and cutting taxes will add fuel to the flames. As demand recovers from the shock of the Covid pandemic, it has revealed weaknesses in the supply side of the economy, which can’t keep up. Some of the problem is worldwide, with the global trading system put under stress by problems in container shipping, for example, or the production of microchips. But Brexit, or more precisely the country’s rapid departure from the Single Market and customs union, has made the problem much worse. On top of that there is the government’s hostile attitude to immigration, especially of people on lower rates of pay. Many immigrant workers have left the country, and don’t want to come back, even if the government would let them. These problems have hit the distribution of goods particularly hard, and imports especially. That matters a lot, because the usual way for the British economy to handle excess demand is to import more. With that option closed, unless the public starts to save more, the consequence is inflation. And sure enough, inflation has risen already. The government is even encouraging it by urging businesses to pay people more.

This is bad news for the government. Inflation is a corrosive economic disease that attacks savings, and usually hits the less well-off, and those reliant on pensions the worst. These are critical parts of the Conservative base (i.e. savers and pensioners). Under the widely accepted understanding of economic policy the way to counter inflation is to increase interest rates, preferably so that they exceed the rate of inflation itself. Right now official interest rates, which drive commercial rates, are very low, and less than inflation. This has enabled many people to afford very high levels of borrowing, usually to buy houses. It also means that the high level of government debt is not actually all that expensive to service (this may not impress followers of Modern Monetary Theory very much, but it matters to the government’s political credibility). Any rise to nominal interest rates will cause widespread pain, which will create a sense of economic crisis. One thing that tends to characterise Conservative voters is ownership of property. Rising property values gives them a sense of wellbeing (even if they have paid off the mortgage), and declining values makes them thing the world is going to pot. If mortgages become more expensive, property prices are bound to fall.

To head this off the government needs to reduce demand. The best way of doing this is to increase one of the broadly based taxes: Basic Rate Income Tax, Employee National Insurance or VAT. Taxes that hit the rich, such as Higher Rate Income Tax, are much less efficient for this purpose, as the rich save more – though they would help with the national debt. The government is, in fact, increasing Employee NI (as well as Employer NI), which will help. It also also trying to cut government spending. It has made a start by withdrawing Covid emergency measures, such as the furlough scheme and Universal Credit. But the politics of large additional spending cuts is awful. Maybe this will all be enough – but I doubt it.

Doubtless the Conservatives hope that within a year the inflation scare will have blown over, and that would give them the wriggle-room they need. And yet many of the supply-side problems that drive it will take years to solve, and may only be solved with a permanent cut to consumption levels. Responding to the problems with pay rises, as the government is encouraging, will also lengthen the time it takes for any settling down.

The chances are that there will be no room to cut income tax before the end of this parliament. Tory party managers should be thinking of other ways of trying to securing political advantage.

3 thoughts on “The government’s choice: higher taxes or higher interest rates?”

  1. “The chances are that there will be no room to cut income tax before the end of this parliament”

    You don’t really know that. It’s better not to assume anything then you won’t be proven wrong. It depends on how badly the mainstream gets it all wrong. Again!

    Who would have predicted, in 2007 when interest rates were being steadily increased, (why was that BTW?) that interest rates would have dropped, or been dropped, like a stone in 2009? If a tight monetary policy crashes the economy again the only method to restart it will be by a combination of higher govt spending and tax cuts.

    1. No of course I may be wrong – but sticking your neck out a bit is good way to make a point. The point is that I think there’s a bit of groupthink going on and the risks are being underplayed.

      Interestingly that was also true in 2007. People knew about the widespread holding of dodgy derivatives based on the US housing market, but weren’t interested in thinking about the risks – all somebody else’s problem. By mid 2007 it was clear that the system was in peril. By then there was little central bankers could do. And of course interest rates did not fall in 2009 – they skyrocketed. Central bank rates plummeted but the rates the public and businesses payed was a different matter entirely – it was very hard to get a loan at all. Money supply sank like a stone. People like to think that money is controlled by central banks, but to maintain control they have to keep it quite tight – after a long period of looseness they lose control – which is why the were trying to raise there rates in 2007, as I remember it (to try an normalise markets as they put it). They aren’t making quite the same mistakes this time but we still have an explosion of debt and speculation. Adding inflation to the mix makes it quite scary, which is why most people assume it is temporary – it is too awful to contemplate what will happen if it isn’t. Groupthink again.

  2. “…it was very hard to get a loan at all”

    Yes this is a good point. It could go the same way again even if there is no rise in interest rates. Just the general perception that they will probably have to rise will be enough to convince everyone that asset prices have reached their peak.

    Even if borrowers might still want to borrow, potential lenders will be more risk averse. For obvious reasons, bankers like rising asset prices, and are scared of falling prices, just as much as potential borrowers.

    So from a control theory perspective, in the engineering sense, the feedbacks look to be highly positive, which indicates a highly unstable system.

    So I would say we are in general agreement that there are severe dangers ahead even if we disagree on the precise reasons.

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