Treasury orthodoxy risks strangling growth

The UK needs a new economic policy after the financial crisis, Great Recession and Brexit. The new Prime Minister will be able to reset the economy and increase UK’s competitiveness and attract FDI.

A new research paper from the Centre for Brexit Policy (CBP) argues that HM Treasury’s arguments for higher taxes are defective. The current Treasury orthodoxy to raise taxes to strengthen public finances and reduce the debt-to GDP ratio is rooted in outdated lessons learned from the 1980s, when economic conditions were very different.

Current policies will result in lower growth and lower tax revenues. The debt-to-GDP ratio will spiral upwards to 135 per cent of GDP (from 90 percent in 2022-22) by the middle 2030s. This is due to (1) Economic growth being slowed down by business taxes. (2) Higher NICs add to the drag on output and competitiveness.

Growth risks being undermined by a ‘doom loop’ from the interaction of economic policy with the economy. While the CBP claims that tax increases are meant to strengthen public finances, it will actually have the opposite effect and destroy growth. In addition to the gradual defeating of inflation via higher interest rates and reversing commodity price movements, higher taxation could lead to a severe recession and significantly lower growth over the long-term.


Featured

Firearms licensing inconsistencies “are symptomatic of wider police failures”


Featured

BASC logo

BASC responds to the England Deer Strategy

HM Treasury wants taxes to rise to reduce post Covid deficit. Higher taxes reduce the incentive to entrepreneurship and lower consumption, investment, and GDP growth. Because of the supply-side economic damage, the end result will be a lower numerator and a lower denominator in the public debt to GDP ratio. As with everything else, actions have their consequences in the tax realm. If you tax something, it will be less.

We need to increase the supply-side appeal of the UK economy. 1980s was the only decade that saw dramatic supply-side policy reforms in the last 50 years. Guess what decade has had the fastest growth rate in GDP over the past 50 years? It’s not hard to guess. The 1980s saw an average growth rate of 2.8%, while it was 1.7% in 2010.

So what is the reset?

The tax rates should be set to maximize growth over the long term. The UK needs a tax system that is 21st century-ready and generates stable revenues, but doesn’t penalize saving or provide incentives for people who are successful. At present the tax system contains a mass of high marginal tax rates, such as the 45% additional rate and the withdrawal of the personal allowance (losing £1 of personal allowance for every £2 of income above £100,000) which creates a 60% marginal tax rate.

The fact that HM Treasury seems to be in no hurry to address this glaring deficit in the tax system, which has been in place since 2010, speaks volumes about its lack of concern for the negative supply-side effects of taxation.

Trade liberalisation and deregulation are the other pillars of supply-side reform. These will have a greater economic impact if we continue to pursue them after Brexit. To be able to sign trade agreements, we must sign many. This allows for unilateral free trade and lowers UK import prices to the world. According to the GTAP trade model – used by HM Treasury – this could bring long-term gains of 4% of GDP via lower prices to consumers and competition led productivity increases by UK producers.

Professor Patrick Minford’s modeling (in the CBP Paper) shows that the gain would be twice as great if we removed half of the EU level protection. Astonishingly, the Treasury believes the gains from free trade will be only 0.2% of GDP on the grounds that this policy will barely be carried out – despite it being stated Government policy. Moreover, the Treasury also assumes that post-Brexit, ‘new’ trade barriers costing 5% of GDP will emerge over the UK-EU border, even though these would be illegal under WTO rules.

The EU Law has been translated into UK law. The new Prime Minister should take up a scythe. There is a huge opportunity to boost Britain’s competitiveness by reducing product and labour market, environmental and City related red tape.

According to CBP modelling ‘business as usual’ fiscal policy results in the public debt to GDP ratio reaching 70% of GDP by 2029-30 and 125% by 2034-35. However, Liz Truss’s announcement of a reversal of Corporation Tax and NICs and delay in the environmental levy result in the debt ratio dropping to 63% by 2029-30 compared to 52% by 2034-35.

Most exciting though is the potential supply-side consequences of a £100 billion fiscal stimulus package (cutting corporation tax by 10%, abolishing the 5% additional income tax rate, cutting the top rate of income tax to 30% and the standard rate by 5%). If constant spending is assumed, this will reduce the debt ratio by less than 70% in 5 years and 50% by the end the decade. This raises the possibility of a budget surplus in the 2030s. This would allow for deeper tax cuts and further supply-side growth. What a prize! The new Prime Minister should reflect on the fact that those who have received much deserve much.

Professor Graeme Leach holds a visiting professorial position in economic policy at University of Lincoln.