Multiplier Madness vs Laffer Lunacy: a guide to Trussonomics
There was no particular element in the mini-budget—no tax cut or spending increase—that caused bond yields to soar and the pound to plummet in value. Rather, it was the totality of all these policies, which together seem to put the ratio of national debt to income on a permanently rising trajectory. This indicated to both the currency and bond markets that this government had abandoned the traditional conservative value of fiscal rectitude.
First was the decision to cap energy prices, creating an unlimited liability on the Treasury whose cost may ultimately exceed one hundred billion pounds. It would have been far more efficient, and indeed ideologically consistent, to allow prices to rise to reflect the growing scarcity of energy, and encourage conservation of a suddenly limited resource. The motivation for adopting what was, after all, the Labour Party’s plan was to prevent a spike in headline inflation. Some measure of temporary assistance to the neediest would have been far cheaper, and reduced the chance of shortages and rationing.
By contrast, all the tax cuts originally proposed were consistent with Truss and Kwarteng’s free-market sympathies, and should, as they claim, enhance growth over the medium term by incentivising work and investment. For example, lower taxes on capital income means more investment, and more investment means more capital. More capital means higher productivity, though the pace of improvement will decline over time as diminishing returns set in, unless the investment engenders greater innovation. So, yes, supply-side economics does work—to a degree. However, imagining that these tax cuts will pay for themselves is a species of magical thinking akin to the way the left typically justifies its desire for unlimited government spending using a bastardised version of Keynesian economic theory.
A little intellectual history is useful here. John Maynard Keynes was no socialist, but he did advocate robust government spending to offset any reduction in aggregate demand from the private sector during economic downturns and ameliorate the effects of the business cycle. There are strong reasons, based on both theory and empirical experience, to believe that such policies can stabilise economies. How well, and at what cost, remain hotly contested.
These ideas can be easily vulgarised to imply that higher government spending—on education, healthcare, infrastructure, even welfare (though oddly not defence)—is essentially costless. More spending means more demand, which leads to yet more output. Through a mechanism called the ‘fiscal multiplier’, each extra pound spent by the government not only pays for itself, but circulates through the economy and expands it still further. Focusing on demand while ignoring supply, this sort of thinking always sees Utopia as within reach. Call this multiplier madness.
The right-wing version is what I will call Laffer Curve lunacy. Like its left-wing equivalent, it too is tenuously based on solid (indeed, even more solid) theoretical grounds. Tax income at 100 per cent, and the revenue the government collects will quickly fall to zero as people lose all incentive to work. Lower the tax rate from 90 per cent to 80 per cent, and the economic activity being taxed will expand by more than enough to compensate for the lower share of income taken by the government. Yet this is only half the story. As Arthur Laffer himself explained in 1974 using the graph of a simple inverted parabola, a tax rate of zero also yields no revenue for the government; and raising the rate of tax from 10 per cent to 20 per cent may depress some economic activity and shrink the tax base, but still yield more tax revenue. In between, there is a rate of tax above which tax cuts more than pay for themselves, and below which tax cuts create deficits. In most instances, this parabola is a bit skewed to the right, so unless the tax rate is already very high—say 65 per cent —there is little chance of cutting taxes without the government’s revenue declining. That was the experience in the US in the 1980s after President Reagan’s tax cuts. The economy expanded, but the debt expanded faster still.
Two years of far too aggressive lockdown financed by profligate spending have left the UK government owing much more than it did before. The bill for this will need to be paid in higher interest rates, higher prices and lower real wages, or higher taxes. Or the new government could embrace lower public spending and shrink the welfare state. This might encourage some share of the nearly one quarter of working-age adults not currently in the workforce to start looking for a job. Better still, they might revisit the triple lock on pension increases to the elderly, which are paid for by young and far poorer wage earners. Radical though they may be, the Prime Minister and the Chancellor know there is little appetite within their own Tory Party for any of this. So instead they chose to do the easy thing: spend more and tax less—and hope that those who lend to the UK government will be swayed by bullish rhetoric.