Sunak's dangerous tax rises are about politics, not economics
The UK's favourable debt dynamics give the Chancellor room for manoeuvre – he should take full advantage of the situation
Rishi Sunak may be too busy putting the finishing touches to his second Budget to notice, but across the pond a political sprint is underway in Washington.
Democrats are racing to get a $1.9 trillion (£1.35 trillion) stimulus bill over the line before the expiry of previous support on March 14, using special procedures in Congress to ram the measures through without Republican support.
When passed, the stimulus will amount to 10pc of American GDP. With the tailwind of a supportive Federal Reserve, the Stateside debate is over whether the vast sums involved will unleash inflation. President Biden wants to see a US economy come “roaring back” and said last week: “The overwhelming consensus is to support the economy, you can’t spend too much. Now’s the time we should be spending.”
In Europe, though, the conversation is much different. The European Union has embarked on a de minimis€750bn (£647bn) fiscal package for a €12 trillion economy drip-fed over several years. In the UK the situation is worse still, as the talk of tax rises lurking in the Chancellor’s red box hardens further.
The arguments against hiking corporation tax on struggling companies are so well-rehearsed as to barely need repetition, from the dampening effect on investment, and the costs which will inevitably pass on to consumers, shareholders and employees indirectly. Even if the first increase is delayed until the autumn, the pain will still be felt progressively in coming years.
We also need to put this squeeze in the making in the context of Sunak’s last big fiscal set-piece, back in November. That was a spending review which clipped £10bn from non-Covid departmental budgets, which will stand £13bn lower by 2025.
Then there was the conference speech last October, in which he talked about his “sacred duty” to ensure sustainable public finances.
But this misses the big picture about the UK’s debt dynamics. The reality is that there is no rush for the Chancellor to do anything: in fact, acting too fast is likely to do more damage.
When looking at the public finances, economists look at the “growth corrected interest rate”. In layman’s terms, this is the difference between the interest rate the UK pays on its debt, and the nominal – that is cash – growth rate of the economy, usually expressed as ‘r-g’. When the debt cost is lower than the nominal growth rate, ‘r-g’ is negative.
When that happens, it means that the level of debt can be stabilised at a higher level or even reduced, even when governments are running a deficit, due to the magic of cash growth in receipts outstripping the interest costs of the debt. Conversely, when ‘r-g’ is positive, then governments need to run primary (pre-interest) surpluses to keep up with the debt costs.
Former IMF chief economist Olivier Blanchard put the concept on the map in 2019 with his presidential lecture to the American Economic Association, which contained the stark line that “public debt may have no fiscal costs”.
This is not to say that Sunak has a free hit. If the Chancellor went on a roller-coaster debt binge, the bond markets would soon cotton on and prices would rise. The leeway available to him relies on debt costs staying low and inflation staying under control.
The Bank of England is also there in the bond market as a buyer of the debt, keeping costs down; but the longer this goes on, the potential of its actions to distort the economy becomes greater, through fuelling asset price bubbles, for example.
Over time, the need to keep the ‘r’ part of the equation down could herald financial repression tactics such as forcing banks to hold more government gilts and artificially suppress its borrowing costs, potentially diverting resources away from more productive private investment.
But the point is that, for now, the Chancellor has wriggle room. There is no sign of runaway inflation, despite a mini-boom in house prices caused by his own stamp duty holiday. Indeed, the slack in the UK economy will be underlined by Tuesday’s labour market figures, where the artificially low headline rate of unemployment belies a steep fall in hours worked compared to a year ago.
Meanwhile there are zero signs of stress or concern in the gilt market and the Bank of England will be buying bonds, in all likelihood, until the end of the year at least. The UK has an advantage of a longer average maturity on its debt at around 14 years, so any interest rate shock would not have immediate effect, even in the unlikely event that the bond market did suddenly turn on us.
The Office for Budget Responsibility rightly points out that the Bank of England’s quantitative easing has shortened our debt maturity, because the billions in bonds it has bought are funded by new reserves which will become more expensive overnight when rate-setters eventually decide to raise rates from their current record low of 0.1pc.
But the Bank’s own forward guidance stresses that this won’t be happening until a significant chunk of economic slack is being used up - and when they eventually do, it will almost certainly be because higher inflation or growth is lifting the ‘g’ side of the equation and the economy is recovering. The Institute of Economic Affairs’ Julian Jessop, for one, believes that this is “more than likely” to offset any higher debt interest payments.
Given all of the above, it seems absurd that the Chancellor would play fast and loose with our recovery through overhasty tax rises without any economic or fiscal justification. But signs such as the vast £16.5bn settlement for defence last autumn suggest he is more focused on political ambitions, and determined to play to the gallery as the guardian of the sacred fiscal flame.
Let’s be clear: Sunak has had a good crisis. After the baptism he’s had, it is easy to forget he is barely a year in the job. But tax rises now are the equivalent of trying to pay the bar tab without knowing the final bill – and if they shrink the tax base by sending more companies under, he risks aggravating the problem he’s attempting to tackle.
While Biden goes for broke, fiscal fetishism could cost us dear.
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