Cutting taxes isn’t irresponsible

Everyone is supposed to have their 15 minutes of fame. Perhaps I have just had mine, after the contenders for the Tory leadership were invited to endorse the ‘charter for tax cuts’ that I co-wrote for Conservative Way Forward. It was certainly pretty cool to be namechecked at the launch event on Monday both by the new Chancellor, Nadhim Zahawi, and by a strong candidate to be the next prime minister, Suella Braverman.

The thinking behind the charter was simple. I wanted to summarise the case for tax cuts and respond to some of the arguments against; including that we cannot afford them, or that they would be inflationary. The timing, as it turned out, could not have been better. The changes at the top of the Tory party are a golden opportunity to rethink economic policy. The government should do much more to lower the tax burden as part of a pro-growth strategy, including proper supply-side reforms and a return to sound money.

Other countries are facing similar economic challenges, but the UK is one of the few to be actively tightening fiscal policy in the midst of a global crisis. This is contributing to a significant increase in the burden of tax, which will soon be the heaviest since the 1940s. Rishi Sunak recognised the need to slow the pace of consolidation and to provide more help to households. Nonetheless, the overall fiscal stance will continue to be contractionary on current plans. The tax system is also becoming more complicated, especially for businesses.

The arguments in favour of cutting taxes are therefore straightforward. It is right in principle: people should be free to decide how to spend more of their own money. Higher inflation also means many people are now paying far more in tax than they – or the Treasury – had expected. Cutting tax is also right in practice, especially now, when the UK needs to boost growth and households need more help to deal with the cost of living. But this is not just about supporting demand. Tax cuts can also help the supply side of the economy by making work pay, and encouraging enterprise and investment.

There is still a danger that some people see tax cuts as the solution to any economic or social problem, in the same way as others might always want more public spending. The Office for Budget Responsibility (OBR) is right to warn that tough decisions will have to be made. A fiscal watchdog that does not bark would not be much use at all.

Nonetheless, there is nothing fiscally responsible about tax increases if they tip the economy into recession, saddling future generations with a weaker economy and even higher bills. In the meantime, there is still plenty of room for a little more borrowing against any sensible fiscal rules. According to the OBR’s baseline scenario, the UK’s public debt-to-GDP ratio is actually projected to fall from around 96 per cent now to less than 70 per cent in the 2030s, before rising again. There is no magic number here, but anything less than 100 per cent is fine.

Concerns about the debt interest bill are also exaggerated. The impact of higher inflation on the cost of index-linked gilts will be spread over many years, and the real interest rates on these bonds are still firmly negative. It is not clear either that tax cuts would add much, if anything, to inflation. For a start, the overall level of inflation depends mainly on monetary policy, not fiscal policy. The amount of money the Bank of England prints is the central determinating factor. 

What’s more, tax cuts could actually reduce inflation, both directly (such as cuts in VAT or fuel duty) and indirectly (income tax cuts might increase the incentive to work, easing labour shortages and taking some of the pressure off wages).

Even if the overall impact on inflation is unfavourable, it is therefore likely to be small. To provide some perspective here, initial Bank of England analysis suggests that the recent cost of living support package (costing well over £15 billion) might raise CPI inflation by (just) 0.1 percentage point. It would not necessarily be a bad thing either if we did end up with looser fiscal policy and tighter monetary policy. Most economists agree that the UK has got this mix wrong. A shift in the balance here should support sterling too, which would also help with inflation.

Worries about the impact on inflation have also not prevented Rishi Sunak from cutting some taxes already, notably the large increase in the National Insurance threshold. These concerns are evidently not insurmountable. Which tax cuts to prioritise largely depends on exactly what you are trying to achieve, whether it is a quick boost to demand, more support to lower-income households or the squeezed middle, or improvements in the supply-side performance of the economy.

Everyone will have their favourites here. My own would be to cancel the planned increases in corporation tax, lower income tax by unfreezing the thresholds and bringing forward the cut in the basic rate and do a bit more now on the cost of energy (including cutting VAT on fuel). But regardless of exactly how it is done, the government needs to do more to reduce the tax burden again – and the sooner the better.