When is a budget not a budget? When the government does not want there to be any informed analysis of its economic impacts. The only reason the Treasury has insisted Kwasi Kwarteng’s statement was a “fiscal event” and not a budget – despite a range of measures far exceeding the contents of most budgets – is that, since George Osborne’s tenure, chancellors of the exchequer have been required by law to ask the Office for Budget Responsibility (OBR) to conduct an independent analysis of the measures taken.
And why has the government been so keen to avoid such scrutiny? Because the economic impacts are likely to look very ugly. It is more or less impossible to find an economist who supports the government’s approach, or an economic model able to justify it. Indeed, the financial markets have already given their negative verdict.
The problem is not the prime minister’s ambition to “grow the economy”. Many economists would actually agree with Liz Truss’s attack on “Treasury orthodoxy”, which has focused far too much on reducing public borrowing and debt, and not nearly enough on raising investment and productivity. The UK’s poor economic performance over the past decade has much to do with the tight fiscal policies pursued by Conservative chancellors.
But there are three big problems with the way Truss and Kwarteng are seeking to reverse these policies. First, the government’s attempt to stimulate the economy through income tax cuts is deeply inefficient. As the UK slides into recession, with businesses failing and unemployment rising, it is not unreasonable for the government to inject some demand into the economy to counteract those effects. But income tax cuts are a really poor way of doing this.
This is not simply about their distributional effect. As the Resolution Foundation has shown, by reversing the national insurance hike and abolishing the 45p tax rate on incomes above £150,000, Kwarteng has performed a remarkable act of redistribution to the rich. But the wider economic problem is that much of the tax cut will not lead to higher spending. Give households more money and they will spend some of it, but also save some. And the higher their income bracket, the more they will save.
A much better way of getting money into the economy is through investment. Wise investment – in infrastructure and business – will raise productivity, and therefore increase long-term economic growth. Investment creates jobs, and therefore raises wages and spending. Economists call the rate at which an injection of cash into the economy raises national income the “multiplier”. As the OBR has noted, the investment multiplier is around three times larger than the tax multiplier. Today the best form of stimulus is green investment, in areas such as home insulation and renewable energy, which would also help to reduce fossil fuel demand and meet the UK’s climate goals. (This is Labour’s plan, it might be noted.)
Second, cutting corporation tax (or not raising it as planned) and cutting stamp duty are really not good ways of stimulating economic growth either. There is almost no evidence that lower corporation tax stimulates investment. At 19%, the UK’s corporation tax is already the lowest in the G7, yet UK business investment is also the lowest. (Germany’s corporation tax rate is 30%.) Meanwhile, cutting stamp duty without building any more houses simply raises house prices – which are already growing at their fastest rate for 20 years. This will price more people out of the housing market, and benefit only existing homeowners.
Third, the fact that the government is using borrowing to pay for all these tax cuts makes them an even worse idea. At a time when the chancellor is tearing up his own government’s fiscal rules, it is worth noting that the one fiscal rule almost everyone accepts is the so-called “golden rule”: that, in normal times, governments should borrow only to invest. This is because investment generates growth, which helps repay the borrowing. Almost no economist would agree with borrowing to fund tax cuts. (This is not what Margaret Thatcher did: she only cut tax when there had been sufficient growth to fund it.)
In fact, the government’s fiscal strategy is even more extraordinary than this. The tax cuts announced will cost about £27bn next year, net of the oil and gas windfall tax already announced. The energy bills subsidy schemes for households and business will cost £60bn. Not yet announced, but very likely in the coming full budget, are spending increases: perhaps £18bn to maintain the real value of public service spending given inflation, and perhaps £25bn to raise defence spending from 2% to 3% of GDP. In total, it seems likely that the government will be borrowing up to £130bn more in 2023-24. Last year, the government borrowed £169bn (a historically high figure; before the pandemic it was about £50bn). So that is a remarkable 75% increase in borrowing.
Can the government borrow this much? Certainly. But only at a price. That price can already be seen in the yields purchasers of government bonds (“gilts”) are now demanding. Already today, UK bond yields are up sharply, having already been rising for the past couple of weeks since the new government took office. Coupled with the interest rate rise announced by the Bank of England on Thursday (with more almost certainly still to come), that makes the government’s borrowing more expensive, creating an even bigger deficit.
And that’s not the only reaction of the financial markets. Over the past two weeks the pound has fallen to its lowest level against the dollar for 20 years, and it is also down against the euro. It fell again after the chancellor’s speech. The markets are signalling their anxieties about the government’s strategy and its impact on the economy. Why does this matter? Because a lower pound raises import prices, thereby pushing inflation up. And it also makes gas (which is priced in dollars) more expensive, thereby raising the cost of the government’s energy bills scheme even higher.
This is a potent brew of economic reaction. There is open talk now of a possible run on the pound, and gilt yields rising even further. A former member of the Bank of England monetary policy committee said this week that if he were an investor he would short (bet against) the pound. If their radical fiscal plan goes wrong, Truss and Kwarteng might find themselves shorted in the political markets.
Michael Jacobs is professor of political economy at the University of Sheffield