The economic puzzle

I have no sympathy for either of the Conservative leadership candidates, and I wish they could both lose.  The prospect of the economically illiterate Liz Truss as prime minister is appalling.  However, I do have some sympathy for the dilemma that they face with regard to fiscal policy and indeed economic policy more generally.

Conventional, especially Keynesian, economic thinking holds that monetary policy and fiscal policy should be consistent and reinforce each other.  Thus if the economy is “overheating” (i.e. low unemployment, labour shortages, inflation well over 2% target) then you raise interest rates (monetary policy) and increase taxes (especially direct taxes on income) and/or cut current public spending (not capital).  Conversely, if unemployment rises and prices are stable or falling, you cut interest rates and increase current spending, especially on transfer payments to the less well off (who are likely to spend rather than save).

What you should not do is raise interest rates while simultaneously cutting taxes since the two measures counteract each other.

However, the current economic situation does not lend itself to this sort of analysis. There are many factors that confuse or obscure the picture:

·         The effects of Brexit, such as decline in EU trade and reduction in the labour force, have not yet been sufficiently identified.

·         Similarly, the long term effects of Covid (e.g. in reducing the economic activity rate) have not been fully identified.

·         The economy has still not fully recovered from the misguided “austerity” policies of the Coalition Government (2010 – 2015).  Real incomes have barely reached 2008 levels while the severe cuts in some categories of public expenditure (especially local government services) have not been made good.

·         Monetary policy is not controlled by the Government but by the Bank of England (unless the Government revokes its independence or changes its mandate)

·         The high rates of inflation that are currently forecast are primarily due to world commodity price increases, especially of oil, gas and grain, in part caused by the war in Ukraine.  This represents a long term change in the international terms of trade that must necessarily reduce living standards in the UK and will impact especially on the less well off.

·         Attempts to compensate for falling living standards by seeking wage increases to match the rate of inflation would be likely to increase inflationary pressures and expectations.

·         Reductions in direct taxes (i.e. income tax, national insurance and inheritance tax) do not benefit people who do not pay the tax (the less well off) but benefit primarily the better off.   Reductions in indirect taxes (VAT, excise duties, fuel duty etc) have a more general effect, depending on personal lifestyles and patterns of expenditure.

 

So what should the next Chancellor do?

A good starting principle is that if you don’t know what to do it is probably best to do nothing, as anything you do is as likely to make things worse as make them better. That is certainly true of the current fiscal situation. However, there are some things that need doing regardless of the immediate budget challenge.

Firstly, the “cost of living crisis”.  Tax cuts are largely irrelevant to this since the most vulnerable people do not pay much tax (apart from tobacco and alcohol taxes, which are more or less voluntary).  The only practical solution is transfer payments.  Moreover, since the factors that caused the “cost of living crisis” are long term and probably permanent (the increase in commodity prices, especially oil, gas and food), a one-off cash payment will not be sufficient.  It needs to be a permanent real increase in the incomes of the poorest.  The £20/week supplement to Universal Credit should be reinstated (and backdated) and all other benefits should be considered for permanent substantial uprating.   While inflation is at current levels, benefits should be uprated twice per year instead of annually.

Secondly, review recent tax decisions:

·         The increase in National Insurance should be replaced by an increase in income tax.  NI is an unfair and regressive tax since it only affects employment income, exempting pensioners and unearned income, and is not levied on higher incomes.  In the medium term it should be abolished and merged with income tax. In the short term, the standard rate of income tax should be increased (perhaps to the level that applied when Margaret Thatcher was in office – i.e. 25%), and the higher rates increased accordingly.  Or the rates could be arranged in more bands cutting in at increasing levels of income

·         Corporation tax should be increased to match the levels of the UK’s main international competitors (>25%).  (If NI is abolished, the employer’s element should be merged with Corporation Tax).

·         Several of the other changes in the 2022 spring budget should be reversed, including:

o   The cut in air passenger duty (it should actually be increased on environmental grounds)

o   The cut in fuel duty (similarly, on environmental grounds)

o   The planned cut in the standard rate of income tax in 2014 (as suggested above it should be increased)

 

Above all the obsession with economic growth should be abandoned.  Some economic growth may be desirable (e.g. resulting from investment in green energy and energy-saving measures), but most is likely to lead to higher consumption, pollution and environmental damage.

 

The UK is a relatively wealthy country and does not need to be any richer.  It is far more important to redistribute the existing GDP more fairly than to increase it.