Taxes: to cut or not to cut? That is the question

11 mins. to read
Taxes: to cut or not to cut? That is the question

When not if” – Rishi Sunak

On Tuesday (12 July), at the official launch of his Conservative party leadership campaign, Rishi Sunak vowed to reduce the tax burden, declaring that it was a matter of “when, not if”. But he also said that immediate tax cuts were not “credible” and could only occur after the current bout of inflation had been beaten: “Once we have gripped inflation, I will get the tax burden down”, he stated. This reinforced the message in his slick campaign video which emerged last Friday (8 July) within 36 hours of Boris Johnson’s resignation. In the video, he enquired: “Do we tell ourselves comforting fairy tales that might make us feel better in the moment but will leave our children worse off tomorrow?”

Sunak is evidently the frontrunner; but he might yet slip up. The Conservative party is a ‘slithery beast’ and can always surprise. Most of the other candidates identified themselves as ‘born-again’ tax-cutters. Apparently, many of them do believe in fairy tales.

Sunak’s chancellorship, which ended when he resigned on 5 July, was tarnished by his reversal of the downward trajectory in the level of corporation tax inaugurated by George Osborne. According to Johnson loyalists, he repeatedly refused to reconsider the increase in corporation tax from 19 to 25 percent. He then hiked national-insurance contributions (admittedly while alleviating the impact on low-paid workers by raising the threshold for paying NICs to the same level as for income tax). He also presided over a badly executed business-loan scheme that was exploited by fraudsters to the tune of £4bn (some say much more). Then he imposed “windfall” taxes on the profits of the oil majors – a Labour party policy initiative. The total tax take this year is expected to be at its highest level as a proportion of GDP for 70 years. Will the Tory party membership vote for a serial tax-hiker who promises jam tomorrow?

Sunak might say that he successfully presided over the economy in the unprecedented economic conditions caused by the coronavirus pandemic. His critics would say that during his tenure the government became addicted to overspending, overborrowing and overinterfering in people’s lives. But would he win in 2024? His supporters’ latest slogan is: “He doesn’t cut taxes to win elections. He wins elections to cut taxes”.

Whitehall is broken” – Penny Mordaunt

The premise of Penny Mordaunt’s economic plan, as set out in her campaign launch on Tuesday, is that debt as a proportion of GDP should fall over time. And yet she has been speaking about the need for immediate tax cuts. She wants to cut fuel excise duty by a whopping 50 percent, which would cut the cost of a litre of unleaded petrol by about 27 pence, from around £1.85 to £1.58 – but that might cost the Treasury around £15bn. She also wants to raise personal allowances (for income tax) at least in line with inflation.

More money in your pocket” – Liz Truss

“I would cut taxes on day one as prime minister”, Liz Truss told the press last Sunday (10 July). She said that she would reduce the increase in NICs introduced in April and attempt to “shrink the size of the state”. Truss was chief secretary to the Treasury for two years (June 2017-July 2019) and thus understands the way the big-spending departments compete with one another for resources. She has been a government minister continuously for 10 years.

Unilateral economic disarmament” – Kemi Badenoch

“There will be no free lunches”, said the member of parliament for Saffron Walden, who is also a former Treasury minister, at her campaign launch. She stands for free markets, limited government and a strong nation state. She desires a “fairer, freer, wealthier and more united Britain”.

An engineer by profession, Badenoch believes that we should approach the country’s economic woes (which I discussed here last week) in a structured manner. She says: “We can only deliver lower taxes if we stop pretending that the state can do everything”. Efficiency savings are not enough, she argues: it is the scale and scope of government itself which is the problem. I took this to be a swipe at the social-care levy, which will involve the effective nationalisation of care for the elderly.

When she observed that the UK government is taxing more and spending more than ever before and yet levels of satisfaction with public services are in freefall, she articulated a fundamental paradox. There are too many young people burdening themselves with debt by getting university degrees which do not guarantee them well-remunerated employment. Schools are insufficiently “rigorous”. The police should focus more on neighbourhood crime and less on people whose feelings have been hurt online. The net-zero agenda should be relaxed.

Badenoch’s remarkable success in the contest so far is one of its big surprises. She has garnered the support of numerous members of the party ‘top brass’, including that of Michael Gove. Aged 42, she grew up in Nigeria and contrasts the standards of governance in this country with those in the land of her birth. She says we can cut the aid budget (a shibboleth of the Tory left) without compromising the effectiveness of our overseas aid.

A clean start” – Tom Tugendhat

Tom Tugendhat, who has never served in the cabinet but has chaired the foreign-affairs select committee since July 2017, claims to have produced a “ten-year plan for growth”. He proposes to cut fuel duty by 10 pence a litre straightaway. He would scrap the increases in NICs (to be labelled the social-care levy from next year) and the increases in corporation tax. He aspires to make the UK the most investment-friendly tax regime in the OECD within five years. He thinks deregulation will be the key to attain that goal, as well as lower taxes. He would scrap the EU’s Solvency II regulations which restrict insurance companies from investing in new projects. Tugendhat also wants to beef up our nuclear-power capacity.

Government as trade-off

Conservatives talk about being in favour of low taxes because they believe that more businesses are launched and more thrive in a low-tax environment. They think people have a right to keep as much of their incomes as possible. But, of course, public services must be adequately funded. At the same time Conservatives believe that they have a duty to maintain public finances in good order – “fiscal discipline” is a term that has been much bandied around this last week. Therefore, excessive borrowing to finance spending programmes should be avoided, though in extreme circumstances (such as in a pandemic or a war) the conventional strictures should be relaxed.

All the candidates agree that the UK debt-to-GDP ratio, currently around 96 percent, is much too high and should certainly not be permitted to exceed the 100 percent mark which economists Carmen Reinhart and Kenneth Rogoff regard as a dangerous tipping pointi. That is because, beyond that point, it becomes almost impossible to reduce the debt-to-GDP ratio without social disorder, especially at a time of rising interest rates. As I reported last week, the OBR has warned that UK national debt is on an “unsustainable path”.

The degree to which the financial markets approve the fiscal discipline of a country is reflected in the sovereign-bond markets. The yield on the UK government’s 10-year gilt stands at 2.1 percent – well below the yield on the 10-year US Treasury note of 2.944 percent. Evidently then, the markets do not fear a fiscal meltdown in the UK – at least not yet.

All in all, Conservatives believe that taxes should be as low as possible, commensurate with financing a necessary level of government expenditure without excessive borrowing. What is “necessary” is always subject to debate. As I explained here two weeks ago, energy policy should be considered as an optimisation exercise between the competing goals of energy security, environmental sustainability (meaning minimal carbon emissions) and affordability. Fiscal policy is an optimisation exercise as well.

One of the few tools that economists have developed to model this optimisation process is the Laffer Curve. Formulated by economist Arthur Laffer (born 1940), the Laffer Curve depicts the relationship between tax rates and the amount of tax revenue collected by governments. The curve is often used to advance the argument that cutting tax rates can result in increased tax revenue.

Imagine a state with a single tax, the rate set by government. If the rate is set at zero, then tax revenues will also be zero (we can all agree on that). However, if the rate of tax is set at 100 percent, the Laffer Curve postulates that revenues will also be zero because no one will consider it worth working at all and the entire population will stay in bed. There are in fact numerous assumptions behind this – in real life, the entire population would work in the black economy, but the general idea is reasonable. So, the curve that relates tax revenues (vertical axis) to tax rates (horizontal axis) is roughly a semicircle, starting at the origin. Any tax rate beyond the apex of that semicircle generates negative marginal revenue.

That’s all very well, but economists cannot agree where that apex or climax point is in the real world. Nor is it clear that the central objective of government is to maximise tax revenue, though clearly governments need to raise sufficient revenues to finance their spending programmes via taxation − anda judicious amount of debt for this purpose is a gain for the financial system.

Any prospective prime minister or chancellor who advocates stimulating the economy by cutting taxes needs to explain how they will fund the inevitable fiscal deficit thus arising. Since the financial crisis of 2008-09, successive chancellors, notably George Osborne, have managed to square the circle by being fiscal conservatives yet “monetary activists” at the same time.

They granted the central bank, The Bank of England (BoE), carte blanche to open the money ‘taps’ and to flood the economy with new money thanks to near-zero interest rates. What has changed – and very few serious people seem to have noticed this – is that this is now over. Central banks, if they are to retain any credibility at all, will have to raise interest rates rapidly to combat entrenched inflation. Further, quantitative easing now looks out of date. Every one percentage point hike in the base rate, according to the OBE, will cost the Treasury over £20bn or about 0.8 percent of GDP.

Henceforth, finance ministers everywhere will have to inhabit a more historically ‘normal’ world in which the price of money (interest rates) reflects an equilibrium of supply and demand for that essential commodity. In pure Keynesian economics, the interest rate stabilises at the level where savings equal investment. Where rates will end up and how quickly is something I’d like to consider here soon.

Interestingly, the only candidate who has stated that governing is a process of negotiating trade-offs was Badenoch.

Kissing hands

The final two candidates in the Conservative leadership race will not be known until next Wednesday evening (20 July). Members of the 1922 Committee have decided that there will be three further ballots on Monday, Tuesday and Wednesday next week. The TV debate between the remaining five candidates will take place this evening (15 July). That should be interesting.

The winner will be chosen from the final two candidates by the 180,000 or so members of the Conservative party (unless one of the final two bows out, as happened with the selection of Theresa May in July 2016). Tory party members are usually characterised as older and more right-wing than the multitude of Tory voters at large. In fact, they are principally men aged over 50, from the south of England and from the A, B or C1 demographic (that is, middle class). Tory party members notoriously favour the death penalty for the gravest of crimes – something that was mainstream when I was born but which offends “progressive” elements of society today.

Sunak is perceived by Tory party members to be a centrist, even though he has invoked the spirit of Margaret Thatcher. He will probably have to face the run-off against a more overtly right-wing candidate in the form of Mordaunt or Truss. The new leader will be announced on 5 September, at which point Johnson will take a mournful car journey to Buckingham Palace (or maybe Windsor Castle) to submit his resignation to the Queen.

All the candidates for Tory leader and PM are in their forties, so none of them remembers the 1970s, the last decade that the inflationary genie escaped its bottle. I seriously doubt that any of the candidates have any idea just how dire the short-term economic outlook is, and by how much living standards will be put under strain. The cost-of-living crisis will be even worse in the first half of 2024, when the next UK general election will most likely take place.

None of the candidates is proposing organisation-level solutions for the systemic failures currently afflicting the ambulance service, for example. And there are few credible ideas about how to boost the efficiency of our other flailing public services, many of which are likely to experience strikes soon.

The deterioration in living standards and the persistent inflation now unleashed – partially due to the “monetary activism” of the BoE − will inevitably favour Labour and their more genteel but even more woke acolytes, the Liberal Democrats. The Scottish National party will work itself up into a lather as never before – because of course it’s all the fault of the English, obviously. I can’t see any of the remaining five winning an 80-seat majority in 2024 as Boris did in 2019.

As he goes into exile, many of the Tory grassroots supporters will toast Johnson, like Bonnie Prince Charlie, as the ‘king over the water’. The new leader will have no comparable capacity for mirth. Leadership requires a complex skill set; but an essential component is to inspire optimism amongst their followers. Boris did that in spades – at least before Covid. All these five candidates leave me anxious; although the most impressive analysis of what has gone wrong in the UK was advanced by Badenoch who could well emerge as the next chancellor if not the next PM.

Over the last 15 years, Australia has had seven prime ministers. We seem to be going that way too.

i See This Time is Different (2009).

Comments (1)

  • Ian Davies says:

    You quote that the tax take by Sunak has risen to the highest percentage of GDP for 70 years. The tax collected is only one side of the equation. The other is that the GDP is, according to some experts, currently running at 5% less than it should be due to the single factor of Brexit ! Though, of course, Sunak is also partially responsible for that mistake as well.

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