Tax cuts present a difficult balance of smart money and smart politics

With a UK General Election widely expected next year, attention is turning to what the Conservative government’s pitch will be on tax. Indiscreet advisers have already trailed to their media friends the prospect of a “retail offer” in the Autumn Budget. This would be an offer designed to illustrate a dividing line between Conservatives and Labour on tax. It is unclear whether this fermenting of expectations originated from Cabinet ministers, or whether it was over-zealous advisers and backbenchers trying to frame the UK economic debate. Either way, the recent increase in interest rates will make delivering tax cuts a precarious endeavour. With Prime Minister Sunak and Chancellor Hunt having staked their reputations on bringing down inflation and government debt, the chances of a material cut in tax must now be extremely slim.   

Whilst the rise in mortgage interest rates is most-obviously painful for the UK’s 8.5 million mortgaged households, the UK public finances are also vulnerable to similar forces. The interest rate paid by the UK government to borrow for ten years has risen sharply towards 4.5%. This interest rate had been as low as 3% as recently as February. The government’s tax and spending watchdog, the Office for Budget Responsibility (OBR), noted in their most recent update that “If interest rates were to be 1 percentage point higher than assumed across our central forecast… borrowing in 2027-28 would be higher by around £20 billion, largely due to debt interest spending. That would wipe out headroom against debt falling”. This very scenario has now played out and puts the Prime Minister’s pledge in January to reduce the national debt under severe strain – even before considering the impact of any tax cuts. 

A few words of caution are warranted before concluding that tax cuts are definitively off the table this side of a General Election. First, and most obviously, the government could conclude that their own political fortunes are simply too intwined with a low tax offer not to gamble. There is a school of thought that Liz Truss’ tax pitch at the Mini Budget was the right idea at the wrong moment, particularly with huge uncertainty over energy prices heading into last winter. With energy prices, at least in wholesale markets, down by two thirds from their Mini Budget level the government may attempt a repeat. It would seem like an enormous inflation gamble with consumer prices still rising at more than 8% a year. But if the alternative for Conservative MPs is unemployment at the next General Election there will be those prepared to put it all on red.

Second, the outlook for the public finances has many moving parts, of which the interest paid on debt is only one. What happens to employment, inflation, population growth and consumer spending also has a big impact on the government’s financial position. The economic recovery, at least this year, looks rather stronger than the OBR assumed back in March. That forecast foresaw the UK economy contracting by 0.2% over the course of 2023. Even allowing for recent mortgage market volatility, the UK economy is now expected to grow by closer to 0.5%. As a naturally cautious Chancellor, Jeremy Hunt will be aware that better near-term economic data does not provide a basis for permanent tax cuts. That will require progress on reducing working-age inactivity, and higher productivity. Here the data remains dispiriting. 

Third, the government may try and change the rules of the game. Fiscal headroom is a construct of the government’s own rule making, rather than how most households and Times readers may consider their own financial position. In 2010 when former Chief Secretary to the Treasury, Liam Byrne, wrote to his successor informing him “I’m afraid there is no money” the UK national debt was £1.1 trillion. Today this figure is more than £2.3 trillion despite an array of fiscal rules over the last thirteen years. The government could try and engineer itself more space for tax cuts by moving to a “balance sheet” rule. Such a rule considers the assets the state is creating and looks to get debt falling after netting off investment in those assets. As with all fiscal rules, credibility is key. And this credibility is more performance art than hard science. Are financial markets going to be sufficiently convinced by the government’s performance since last year’s Mini Budget? A lot will hinge on whether UK inflation comes down rapidly over the summer months, and this is not assured.

Putting those three caveats aside, the economics of tax cuts remain a source of contention. For some observers the fact that the UK’s tax burden is the highest in seventy-five years is reason enough to take steps to reduce the size of the state. But in 1950 there were just 5.4 million people aged 65 or over. Today there are almost 13.2 million. If you adjust for what economists term the “old age dependency ratio” there is actually little evidence that the tax burden has materially changed over the last twenty-five years. Successive governments have simply chosen to preserve, and in some cases increase transfers to a growing segment of the population.

There is also another point of friction and that relates to the way the OBR look at the behavioural impact of tax cuts, and indeed spending programs. There is frustration in some quarters within government that the OBR are sceptical of policies designed to incentivise economic activity. They contend that these can have big economic impacts beyond the arithmetic impact of cash in, and cash out of the Treasury. The head of the OBR, Richard Hughes, will be looking on nervously as the attacks mount on his contemporary at the Bank of England, Andrew Bailey. Independent economic actors will find their role becoming increasingly political the longer the UK’s bout of sluggish growth continues.

The UK’s economic cycle has always been sensitive to its political one, and the next eighteen months won’t be any different. When it comes to tax however the room for manoeuvre has been heavily curtailed by the big increase in interest rates seen in recent weeks. This was enough for the Labour opposition to scale back plans for their brand-defining spending on green investments. Over to you Mr Hunt and an unenviable choice between smart money, and smart politics.              

TAX CUTS PRESENT A DIFFICULT BALANCE OF SMART MONEY AND SMART POLITICS

Published: The Times 20/06/2023

Simon French

Managing Director, Head of Research