In defence of tax cuts – yes, even now
Foreign Secretary Liz Truss has campaigned on a promise to reverse the national insurance increase, cancel the planned increase in corporate taxes and windfall tax, and put a moratorium on the green levy. By contrast, former Chancellor Rishi Sunak has argued that tax cuts should be delayed until there is a stronger fiscal position, with the exception of scrapping VAT on household energy bills, on the basis of an inflationary risk and to avoid increasing the national debt.
Despite the good faith objections to immediate tax cuts, there is a strong economic case for reducing burdens at this point. The UK is on track for the highest tax burden in 70 years. That risks damaging our living standards. As the Tax Foundation shows, there is plenty of empirical evidence which suggests that higher taxes reduce economic growth, and according to some studies, substantially so.
Tax cuts, along with cancelling planned increases, would put more money into people’s pockets and encourage investment and boost living standards. The UK is pretty much unique in deciding to increase taxes during these challenging times.
But won’t tax cuts lead to higher interest rates?
Monetary policy, through the Bank of England, is responsible for keeping control of inflation. In practice, under the standard “monetary dominance” model, the Bank offsets any additional inflationary pressures caused by higher spending or lower taxes, by tightening monetary policy. It is not the role of fiscal policy, that is, the government’s taxing and spending, as it would require policies nobody is seriously advocating to slow down the economy, such as immediate substantial tax increases. (If a policymaker is of the view that fiscal policy should address inflation it would also rule out handouts for struggling households.)
In any case, the proposed tax cuts are unlikely to have a meaningful impact on the Bank’s decisionmaking. Initial Bank of England analysis of the Government’s recent cost of living support package (costing over £15 billion) suggests that it could raise CPI inflation by just 0.1 percentage points. It is therefore unlikely that, in the context of inflation over 9%, the proposed tax cuts (costing around £30-£40 billion) would be the cause of monetary tightening.
Could tax cuts be disinflationary?
Inflation is essentially “too much money chasing too few goods”. We need a monetary policy response to address the “too much money” side of that equation, but alongside that, an increase the economy’s productive potential – so that there are more goods to chase – cannot hurt either.
Tax cuts have the potential to reduce headline inflation directly, by reducing the cost of goods (lowering VAT) and wage costs (reversing the employers’ NI increase). But in the longer term, there could also be indirect effects. Corporate tax cuts could encourage investment, which boosts the ability of the economy to produce. Personal income tax cuts could encourage more people to joining the workforce or work longer hours, thus helping to address labour shortages.
These supply-side effects are largely over the medium to long-run, and thus are unlikely to meaningfully reduce inflation straight away, but that does not mean they should be dismissed.
Are tax cuts affordable?
Inflation is resulting in higher than expected revenues for the government. The Centre for Economics and Business Research has estimated a £60 billion boost for the Treasury by 2024/25. This is a result of fiscal drag and higher spending in nominal terms, meaning higher VAT receipts. It provides some additional headroom to lower taxes.
What about the national debt?
It is important not to confuse the Covid-related increase in the stock of debt, which can be paid back slowly over many years like a war debt, with an ongoing structural deficit. This means there’s more room for borrowing than the topline figures suggest. Furthermore, the cost of higher inflation on government debt will be spread over many years, while the real interest rate remains negative.
The only effective way to get down the debt will be to grow the economy and cut spending. Tax increases, like those currently on track, can be counterproductive since they slow down the economy, thus increasing the debt-to-GDP ratio. Alesina et. al. found, from studying 3,500 policy changes targeting debt reduction, that tax increases to reduce debt are counterproductive because they lead to a substantial long-term decline in the economy.
Are the UK’s corporate taxes too high?
Under current plans, the UK’s corporate tax will increase from 19% to 25% in April 2023, while the super deduction would come to an end. At the time the former Chancellor announced the rise, he argued that it would be consistent with the Biden Administration’s plan to increase US corporate taxes, however, that did not eventuate. This risks making the UK a significantly less worthwhile place to invest, resulting in lower productivity and wages for workers. The Tax Foundation found that the proposed changes would push the UK from 18th of 37 OECD countries to 31st in terms of the overall competitiveness of our business tax regime. This risks scaring away investment and slowing the economy.
Is inflation driven by corporate greed?
The idea that businesses suddenly became greedy in 2021/22 is patently absurd. Businesses respond to incentives. They have put up prices in response to higher costs (such as wholesale energy, rising labour costs and supply chain issues) and strong consumer demand following loose monetary policy. Businesses are ‘taking advantage’ of the situation to the extent that they are responding to market forces outside of their control. It’s also important to note that price rises encourage businesses to invest in their production and expand output, thus addressing supply-side issues. Price controls to limit business revenues would result in less production and risks disastrous shortages.