In early May a leaked Treasury paper showed that a series of tax increases and spending cuts was being contemplated in order to reduce the high deficits and debt levels consequent on the Covid-19 pandemic. In the paper the Treasury forecast a “base case” scenario in which the 2020/21 UK fiscal deficit rises to £337bn – from a forecast £55bn pre-crisis – and a “worst case” scenario where the deficit is £516bn. In the base case tax rises and spending cuts of £25-30bn are recommended, while in the worst case the package would “need” to be £80-90bn. On the menu of austerity choices were: an increase of 1p in the basic income tax rate (£5bn), an end to the pensions triple lock (£8bn), a two year public sector pay freeze (£6.5bn), and unspecified rises in VAT, national insurance and company tax. New taxes such as an income tax surcharge to fund the NHS or taxes on property and wealth were also contemplated.
The proposals received a lot of criticism and the PM and Chancellor seemed to signal that such measures would not receive their backing. However, in recent days a number of influential organisations and individuals – including the OBR (Office of Budget Responsibility), the IFS (Institute for Fiscal Studies), the Resolution Foundation, the Chairman of the Parliamentary Treasury Committee, and former Chancellor Norman Lamont – have either advocated or forecast significant tax increases. The Labour Party is pushing the introduction of wealth taxes. The Chancellor has now initiated a review of capital gains tax – could this be a precursor to raising revenue raising measures?
Where to start with this madness? In the first instance I retain my relative optimism about the UK’s recovery prospects. The Treasury also produces a “best case” scenario –in my view the most probable – which sees the economy recovering most of its lost ground within 12 months. In that case the 20/21 deficit is “only” £207bn, and even the hair-shirt Treasury sees no need for renewed austerity in this case. However, the Treasury’s base case scenario envisages the massive drops in GDP of the first half of 2020 are only followed by a weak and hesitant recovery. Business and consumer confidence would then remain very low. Swingeing tax rises and spending cuts in those circumstances could only have the effect of weakening the recovery or pushing us back into recession. The impact on the deficit and on future debt growth would then be entirely counter-productive. In the worst case scenario, in which the economy hardly recovers at all, much bigger tax increases and spending cuts are stipulated. This defies all common sense and economic logic, not to mention political reality.
The Treasury seems to have failed to notice that we live in a world of very low interest rates, one in which the dynamics of public debt have become very different. The most authoritative exponent of this more benign attitude to public debt is Oliver Blanchard, former IMF Chief Economist. He argues that in conditions where interest rates on government debt are lower than the nominal economic growth rate – as they are now – public sector debt expansion may have little or no fiscal cost, where fiscal cost is defined as the need to raise taxes in future because debt raised now cannot be rolled over. As a long time fiscal “hawk” I have been fully converted to this view (as set out in a previous July 2019 Briefings paper called “The Case for Fiscal Expansion post-Brexit”). Many fiscal conservatives have been similarly converted, but the memo has not been received in the Treasury’s mouldering Ivory Tower.
This is not to argue that there are no longer term dangers or threats arising from very large deficits and/or high and rising government debt to GDP ratios. However, these threats and dangers are not germane in current UK circumstances. The interest rate on ten year UK government bonds is currently a miniscule 0.12%, having fallen during the lockdown from an already incredibly low rate of 0.75%. Yields on UK bonds with maturities in the 1-7 year range have actually gone slightly negative. The nominal GDP growth rate will be very negative in Q2, but as UK broad money supply growth is rising sharply and the BoE is committed to a substantial bond buying programme the nominal GDP growth rate should return to trend in the medium to long term.
The Treasury seems to envisage a funding crisis akin to 1976 when the UK was forced to go to the IMF for a “rescue” loan. This is a fantasy scenario. The UK entered the Covid-19 crisis with a deficit of around 2% of GDP. The UK government debt ratio was just over 80%, lower than the equivalent level in the Euro area (84%), well below the USA (107%) and many individual EU countries (France 98%, Italy 135%) and positively tiny compared to the Japanese outlier of 238%.The average maturity of UK debt is also high by international standards – some 15 years compared to around 10 years in the EU and only 5.75 years in the USA. All of these countries have taken strong fiscal measures to counteract the crisis and all will see big increases on deficits and debt levels. There seems no reason why UK’s fiscal position and outlook should worsen relative to international norms – it is more likely to improve its standing.
The biggest negative for the UK’s international credit rating is large and sustained current account deficits – averaging 3.9% of GDP over the last ten years. One beneficial consequence of the crisis is likely to be a marked fall in the current account deficit. The crisis is causing a marked fall in world trade. Since the UK is a large net importer of goods, as a matter of simple maths an equivalent % fall in UK exports and imports would result in a lower deficit. The shutdown in international tourism will also cut the deficit as the UK normally spends more than it receives. The very large falls in oil and gas prices will also improve the trade account as the UK is a large net importer of oil and gas.
The UK is therefore unlikely to struggle to sell its bonds to international investors. Furthermore, the BoE will be a massive buyer of UK bonds while the crisis lasts. The new BoE Governor has also made it clear that he does not foresee the need for new austerity measures. From what we know of the new Chancellor he also seems likely to resist these policy proposals. He is however young and only five months in the job, so may find it difficult to overrule his advisers. The role of the PM is therefore crucial. Fortunately, everything we know about the PM tells us that renewed austerity in these circumstances will be complete anathema to him. Such measures not only go against all his instincts but would drive a coach and horses through the Conservative Party manifesto upon which he was decisively elected.
With the PM’s backing the Chancellor should tell his senior officials to scrap these ideas – though there is a strong case for changing the pension triple lock given the lockdown’s impact on inflation and wages – and instead work on finding supply side initiatives to boost the sustainable growth rate. The government already has an agenda which aims to boost productivity and growth – a large investment programme in transport, housing, and 5G broadband, promotion of science and research and of SME’s, the introduction of free ports – and these have become even more important. In selected areas the crisis has stimulated accelerated cooperation between the private and public sectors, and rapid and effective deregulation, with some spectacular results. These can provide templates for future policy. The Covid-19 crisis has also greatly accelerated some pre-existing trends – such as increased digitalisation, home working, online retailing – which may materially raise future productivity levels.
Rather than raising taxes the Chancellor should make tax reform a new centrepiece of the growth agenda. The UK has one of the longest tax codes in the world, a dense thicket of allowances, exemptions, deductions, loopholes, incomprehensible rules, and a myriad of small and counter-productive tax wheezes. In spite of occasional good intentions every Chancellor since the radical tax reformer Nigel Lawson has added significantly to the tax code mountain. I am no tax expert but the outlines of such a programme are clear. First, stipulate that the initial objective of the reforms is not a reduction in the tax burden but to make the tax system much simpler and more efficient. Second, eliminate or reduce the majority of deductions, allowances, exemptions, and minor taxes. Lastly, set the remaining tax rates at the lowest level possible while keeping the package revenue neutral.
A number of policy research bodies have published detailed tax reform programmes along these lines which can form an initial template. The problem has never been devising a tax reform package, but having the political will to implement it. Although the whole economy will benefit from a more efficient tax system, the gains are widely diffused but the losses are highly specific. Every change will be noisily opposed by highly organised lobbies. Many officials (especially in the Treasury) and politicians will oppose such reforms because it removes power from them (a major benefit of the reforms!).
It will never happen without the PM and Chancellor backing it to the hilt. However, the opportunity to do it is more promising than for many years. The government has a large majority. It has a strong mandate to oppose tax increases. The Covid-19 crisis has created a sense of urgency that is making the previously impossible seem doable. The Treasury itself has created large new programmes to assist the economy at a speed unthinkable a few months ago. And the prize is great, because tax reforms along these lines could markedly raise productivity and the sustainable growth rate. The additional deficits and debt caused by the Covid-19 recession could then be brought under control without tax rises or spending cuts. In the longer term tax cuts would become possible. How about it Chancellor?
Robert Lee Former Chief Economist, Board of Executors (South Africa), Economic Consultant (UK), and private investor.