The opening salvos of the Conservative leadership contest have been dominated by tax policy. Most of the candidates have proposed immediate tax cuts. Rishi Sunak, while ruling out that course, said: “once we have gripped inflation, I will get the tax burden down. It is a question of ‘when’, not ‘if’.” At face value any disagreement is about short-term tactics, not long-term strategy. They are all wanting to cut taxes in the longer term.
There are several issues here. Can cutting taxes make a big difference to economic growth, as a number of the candidates have claimed? Is there “headroom” in the immediate term to cut taxes and maintain some form of fiscal discipline, and in particular meet the government’s target of balancing the current budget (borrowing only to invest) by 2024? (Note that would still imply £70bn of borrowing). What about the spending side of the public finances balance sheet? Would a fiscal loosening now pose an inflationary risk? And is lower taxation in the medium to long term a plausible ambition?
Taxes and growth
Economic growth in the UK has been feeble for a good 15 years. We have underperformed most other major European nations, including France, Germany and the Netherlands, which have all grown more quickly than we have since 2007 (and in particular since 2015). Our tax burden is substantially lower than theirs. On the eve of the pandemic, general government revenues as a fraction of GDP (one measure of the tax burden, used and published by the OECD) stood at 38.8 per cent in the UK, versus 43.7 per cent in the Netherlands, 46.7 per cent in Germany and 52.5 per cent in France.
While, other things equal, lower taxes can be good for growth, this is pretty clear evidence that the tax burden is not what has been holding the UK back relative to other countries. You can have taxes much higher than we currently do and have an economy that grows strongly.
The candidates focusing on the UK’s lacklustre record on economic growth are absolutely right to do so. There is a case for reforming or rebalancing taxes to support growth, for sure. But tax cuts are not a silver bullet. Governments need also to be focussing on schools, vocational and further education, planning reform, infrastructure, investment, competition policy and trade. We need to address the fact that we have made trade with our nearest, richest and biggest trading partner, the EU, more difficult and more expensive.
The candidates should also recognise that competent and stable government, and trust in institutions and the rule of law, are all fundamental to creating the conditions necessary for economic success. Without those, investors both domestic and international are not going to have the confidence to take long-term bets on the UK.
In its March 2022 Economic and Fiscal Outlook the Office for Budget Responsibility said that the government’s own fiscal mandate, to have public sector net debt falling as a fraction of national income by 2024-2025, was being met with £28bn to spare. It also said that the target to balance the current budget over the same period was being met with £32bn to spare. This is where candidates have found £30bn of “headroom” to spend on tax cuts.
Anyone serious about meeting these targets would not, however, treat this as an indication that there really is £30bn to spend. In the first place, £30bn is a projection around which there is a lot of uncertainty. A prudent chancellor would not want to reduce the headroom it provides. There are many downside risks associated with current economic uncertainties, and pressures on government to spend more to support households. If you do cut taxes because you see this headroom then you have to be prepared to raise them, and raise them sharply if—as is all too likely—the headroom subsequently disappears.
All of the above depends on the government keeping to spending plans set out last October. At that time the expectation was that inflation would peak at around 4 per cent. It is now set to peak at 11 per cent and stay higher for longer. What originally looked like 3.3 per cent average increases in public service spending above inflation each year now looks substantially lower. Higher inflation has wiped out at least 10 per cent of the budget increases pencilled in last autumn. To compensate public services for higher inflation and return to the intended rate of growth in their budgets, plans would need to be topped up by north of £5bn each year. If anything, this is likely an underestimate, due to a quirk in the inflation measure underpinning the official estimates.
And that’s before we get to public sector pay. Existing spending plans were predicated on pay growth of something like 2 to 3 per cent, and cannot accommodate pay rises at anything like the current rate of inflation. Giving bigger rises without the requisite funding would necessitate cuts in headcount and/or an acceptance that some public service objectives (such as clearing the NHS backlog) cannot be met. Giving bigger pay rises with the requisite funding would eat into the fiscal headroom available for tax cuts. And refusal to countenance bigger pay increases at all risks making it more difficult to attract and retain the skilled workers needed to deliver public services—not to mention widespread industrial action. A package of unfunded tax cuts would only make these decisions more difficult.
It is not possible to say what impact a particular level of tax cuts would have on inflation, but clearly pumping additional money into an economy where prices are rising carries risk. It certainly risks a response from the Bank of England, which might well increase interest rates more than otherwise in response to a significant fiscal loosening. Right now, a prolonged period of high and volatile inflation is probably the biggest risk facing the UK economy. The costs of that are potentially vast and policy should be focussed on avoiding such an outcome; unfunded tax cuts clearly do the reverse.
The longer term
Whatever the short-term constraints, it is abundantly clear that there are long-term pressures on the public finances. After a decade of austerity and the immense disruptions of Covid, all public services are struggling to manage with the resources they have. The backlog of cases in the English and Welsh Crown Court stands at almost 60,000, some 70 per cent higher than at the same point in 2019, and more than a quarter of cases have been open for a year or more. The rates of self-harm and assault incidents in our prisons are on a welcome downwards trajectory, but still remain substantially higher than a decade ago. At best there is little scope for cutting spending on these and other services in the medium term. There seems to be general agreement that spending on defence should rise—or at a minimum not fall below the Nato target of 2 per cent of GDP, as countries across Europe step up their defence expenditure.
The really big pressures, though, will come from health, pensions and social care. It is inconceivable that we will as a society be willing to spend less on these, as a fraction of national income, as the population ages and costs in health, especially, continue to rise. Those pressures might be a little easier to manage over the next decade than previously projected, owing to slower improvements in life expectancy (hardly something to celebrate in itself), but the upwards trajectory is clear.
The levels of overall tax and spend cannot diverge indefinitely. The question, then, must be: if you want to cut taxes and spending as a fraction of national income over the longer run, where are those cuts going to come from? Health? Pensions? Welfare? Schools?
Faster economic growth would help. Relying on it would be foolish. Nobody can guarantee it and it isn’t a cure-all. If earnings in the private sector are growing then we will have to spend part of the growth dividend on public sector wages. Higher growth and higher living standards also result in higher expectations.
There are options to reduce the size of the state. Looking at the big areas of spending, we could ration healthcare more or charge the well-off to access it. We could limit numbers going to university. We could extend the system of higher education loans to sixth forms. We could means test the state pension. We could cut means-tested benefits or disability benefits for the working-age population. We could abandon our commitment to Nato and pare back the defence budget. It is hard to see how one cuts back the size of the state without doing one or more of these, or something equally radical.
Low taxes are preferable to high taxes, and could help growth if well implemented and accompanied by tax reform. There is every case for ensuring that public money is spent efficiently and on the right priorities so as to minimise the tax burden. But we do have to recognise that taxes pay for public spending. Those who wish to see taxes cut need also to say how they will cut spending.