Even the most ardent Conservative party member would be hard pressed to judge Liz Truss’ start in office as anything other than catastrophic.
On the 23rd of September her Chancellor, Kwasi Kwarteng, followed through on her leadership campaign’s promise to lower taxes with the aim of pursuing a higher rate of growth for the U.K. economy. The scale of the expansionary fiscal policy was unprecedented.
- A reversal of the announced rises in National Insurance and Corporation Tax
- A 1% reduction in the basic rate of income tax and abolishing the highest 45% rate
- A program to subsidise a two year price cap on energy bills for domestic users and six months for commercial users
The tax program amounted to the second largest tax cut as a percentage of GDP ever (over 1.5%), while the energy bill relief program is estimated by some energy analysts to cost up to £150bn (although there is no theoretical limit).
You see the issue here. Less money in, more money out.
The motivation for tax cuts was grounded in supply-side economic theory that gained traction through the 1970s and 80s and famously inspired Reagan and Thatcher. The idea is that a lower tax and regulation economy has potential to attract investment from businesses seeking a friendly place to operate. This investment could spur U.K. productivity growth, which has been among the worst in high-income countries since the great recession, and bring economic growth too. Furthermore, Truss is also seemingly enamoured by the Laffer Curve and the idea that a tax reduction could in fact generate higher tax revenue by attracting more economic activity into the economy.
I truly doubt that large benefits can be gained from lower taxes and looser regulation in the already very business friendly U.K. There are also caveats to the successes of Thatcher and Reagan’s policies. Economic growth was strong during their tenures, but it may have simply been the natural course of the business cycle at the time and it coincided with substantial rises in inequality as large parts of the income distribution saw stagnating wage growth.
Irrespective of the questionable merits of the policy program, the timing was arguably more problematic. Through the COVID-19 pandemic, the government implemented significant income support through the furlough scheme, ran significant deficits and borrowed large amounts of money. This was essential spending that diminished the effects of an unprecedented economic shock.
The government’s hand has been forced again to shell out to subsidise soaring energy bills that could otherwise cripple the economy. But at the same time they decided to make large tax cuts and borrow more. Fitch, a firm that assesses the reliability of debt issuers, forecasted gross U.K. government debt to rise to 109% of GDP by 2024 under the policy proposal instead of falling as expected.
Typically, after large amounts of debt is taken on, fiscal conservatism is followed (such as that seen after the world wars), to reign in debt and ensure the market doesn’t stop lending to the government in fear of not being paid back.
Excessive debt-financed spending is problematic in any period, but now is a particularly precarious moment. Inflation is very high; some government bonds are linked to inflation and so government debt interest payments were already rising. Cutting the lowest rate of tax is likely to fuel inflation further. The U.S. dollar is being strengthened by higher interest rates that make it more attractive to move money out of pounds and into dollars, making the Pound weak. This makes U.K. bonds, which are repaid in pounds, less attractive and meaning the government is once again forced to make higher interest payments.
The mini budget sent the pound tumbling and U.K. government bonds went into a tailspin over concerns that fiscal sustainability has been thrown out the window. The tax cuts are substantial and the spending on energy support is even bigger. However, perhaps a more worrying aspect of the announcement was the omission of a review by the Office for Budget Responsibility. The OBR typically provides independent scrutiny for government fiscal plans. The government recklessly decided to bypass the process, spurring even greater fear in financial markets.
The combination of high government borrowing at a high yield puts constraints on other government spending priorities as debt interest costs rise further beyond the already dramatic increases expected due to COVID borrowing and high inflation.
Furthermore, the bonds of a government act as a benchmark for the whole economy. If the interest paid on government bonds rises, then households and businesses across the U.K. economy will have to pay higher interest on their borrowings, including mortgages. The U.K. economy is highly indebted and mortgage rates are rarely fixed for longer than two years. This means that people will face increases in their loan repayments putting further strain on struggling household budgets.
Truss and Kwarteng’s policies targeting a long-run stimulus to growth may have instead catalysed a rather dire recession. It is feasible that tax cuts could eventually provide some stimulus to GDP and productivity growth. Any gains are likely to be asymmetric across the economy, but broadly everyone does gain from growth.
The real issue was a mismatch in the time horizons within the policy program. By coupling emergency short-term spending with tax cuts aimed at the long-run trend rate of growth, Truss and Kwarteng managed to cause unbridled panic.
The government quickly rolled back on their removal of the top rate of tax and the new chancellor, Jeremy Hunt, has reverted to Rishi Sunak’s corporation tax plans, scrapped the bottom rate tax cut and scaled back the energy support scheme. With respect to pre-mini-budget levels the pound has recovered, but bond yields remain somewhat elevated. This is despite the U-turns, aid of Bank of England intervention and at the additional cost of enormous uncertainty that almost toppled the U.K. private pension industry. At the very least this fiasco has sacrificed the substantial value that exists in confidence, credibility and stability for governments and central banks.