Cutting taxes means cutting public services or hurting fiscal sustainability

The Tory leadership races have, so far, become a battle over who can promise more tax cuts. Whoever wins, his next chancellor will come under intense pressure, from Tory backbenchers and possibly the new occupant of Number 10, to cut further and faster. At the same time, Treasury officials will warn of the risks of such a move. The new chancellor would be wiser to listen to officials.

Without raising taxes or cutting spending, public finances will head into explosive territory.

Recent tensions between No 10 and No 11 over whether to cut taxes were mentioned by Rishi Sunak in his resignation letter. But the warnings about the impact of the tax cuts are clear, with a new report from the Office for Budget Responsibility (OBR), the government’s official forecaster, warning that public finances are on an unsustainable path. Richard Hughes, chairman of the OBR, said at a recent IfG event that the first question for any leadership candidate calling for tax cuts should be whether they will pay for tax cuts reversing spending increases (eg recent increases in the DHSC budget) or increasing borrowing.

This is mainly due to the increase in health and social care expenditure, a consequence of the aging of the population and the increase in costs in the health sector. The second most important factor concerns state pension expenditure, which is expected to increase significantly, also due to the aging of the UK population and the current “triple lockdown” policy.

With ambitious policies stabilizing and net zero requiring a significant amount of additional public spending, and the possibility of very limited additional “efficiency” savings given the last decade of cuts, it is easy to see why Most recent chancellors have chosen to raise the tax burden rate to historic highs to balance the books. This is too often interpreted as a contradiction to conservative principles or as an expansion of the state, whereas it rather reflects the fact that the provision of basic public services such as pensions and health and social care is becoming more expensive. Public expenditure (and taxation) would increase even if there were no expansion of the functions of the state, and similarly, keeping borrowing and taxation at an equal level would necessarily correspond to a real reduction in the provision of public services (per capita).

Broad-based temporary tax cuts would fuel inflation

The new Chancellor may think a temporary tax cut would be a good option to help ease the cost of living crisis and would mean limited long-term budgetary implications. As we recently argued, that would also be a reckless move. Such broad-based measures would be costly and aggravate the inflation problem while being unlikely to significantly stimulate demand. They would also be unlikely to contribute to the cost of living, since the Bank of England would respond by raising interest rates to counter the inflationary impact of the policy. Such policies are also difficult to reverse and risk becoming permanent – ​​all the more so if the government in place is weak, close to an election, or both.

The argument that tax cuts will pay for themselves by stimulating growth is nonsense

Some proponents of tax cuts – particularly corporate tax cuts – argue that they can pay for themselves by stimulating more investment and growth. This is not a view shared by the OBR: when Rishi Sunak announced his intention to raise the corporate tax rate by six percentage points to 25%, the OBR acknowledged that there would have a modest negative impact on investment, but that the change would still bring an additional £17bn in revenue by 2025/26. [1] Richard Hughes, Chairman of the OBR, also noted at the Institute for Government event that over the long term there is no relationship between the tax burden and growth, factors on the side of supply such as labor, skills and capital playing a much larger role. role.

The argument that tax cuts can generate revenue is not supported by much evidence. The only cause for concern might be if UK tax rates were much higher than in other countries (causing businesses and people to relocate) but, even with the latest six percentage point increase , the UK remains in the middle of the pack of advanced economies when it comes to the effective corporate income tax rate.

The evidence, should the new Chancellor act on it, would lead them to reject calls from No 10 and backbench MPs for sweeping tax cuts. Such a move would jeopardize fiscal sustainability, public services, or both in the long term. It would also be inflationary in the short term.

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  1. https://obr.uk//docs/CCS207_CCS0221988872-001_CP-387-OBR-EFO-Web-Accessible.pdf