Kwasi Kwarteng’s mini-budget has been widely panned by orthodox economists and the pound and Gilts fell sharply on Friday. There are concerns over the budget’s unfunded tax cuts and the fact that by providing a Keynesian-style stimulus to the economy it will force the Bank of England to raise rates higher than previously expected. So, is this criticism fair? And is there anything good to be said about the mini-budget?
Sterling’s reaction is concerning. Normally a switch in policy towards fiscal ease with greater monetary tightening (as widely expected from the Bank of England) would strengthen a currency (via higher rates). But Sterling fell 3.6% vs the USD on Friday and about half that vs the euro. Investors are presumably scared that policy is being made without careful consideration of the implications for borrowing (higher). There may also be concern that the profligate spending by Johnson’s Conservative administration and now the aggressive tax cuts by Truss’s government might give the Labour Party ideas, if it wins the election due by 2024. It will be worth watching to see if the Labour Party tries to campaign on fiscal rectitude, which might lock it in to prudent policy. That is what happened in 1997 and made for a successful Blair first term. Or will it keep the tax cuts and plan more spending?
The tax cuts amount to about £50bn and are the biggest since the so-called ‘Barber boom’ of the early 1970’s which ended in inflation. But the Barber boom involved both fiscal and monetary easing. This time interest rates will rise to counteract the fiscal stimulus. Of course, the rise in interest rates will add to the deficit too. Each 0.5% rise in rates adds about £5bn to borrowing. However, as the Institute for Fiscal Studies notes, all these tax cuts merely return the tax burden as a percentage of GDP to 2021-22 levels (i.e. last March). The problem obviously is that GDP growth is so weak.
The official OBR did not provide a forecast this time, something which may have helped unnerve markets. Having an independent fiscal watchdog is a great check on governments. But the NIESR projects net debt to rise to 91.6% of GDP in 2024-5 instead of falling to 87.5%. The difference is not scary but the direction is. Markets want to see the ratio on a falling trajectory at least in the out-years.
Further, stimulating the economy when unemployment is at a 50-year low is risky to say the least. Commentary often correctly points out that the current approach is not Thatcherite – since she was a strong believer in balanced budgets – but more Reaganite, as he cut taxes in the early 1980’s. But that followed the worst double-dip US recession since WW2 and US unemployment was at 9%. Truss and Kwarteng are taking much more risk with inflation than Reagan was. Paul Volcker then kept monetary policy fairly tight which saw the USD soar to high levels (the last time the pound was under $1.10). Clearly this isn’t working the same way for Kwarteng.
Timing is everything
Trying to look on the bright side for a moment, perhaps the fiscal stimulus will come at a convenient time. The UK is already in recession and GDP was set to decline further for the next 2-3 quarters at least due to the rise in energy prices. Normally, economists are sceptical of using fiscal policy as an anti-cyclical policy because it is so hard to get the timing right. But the timing could be right this time as reduced NICs will boost pay packets in November while the 1p income tax cut will come next April.
On the NIESR forecast this stimulus is bad news because the recession won’t be deep enough to reduce wage inflation without raising interest rates much more. But this might be wrong. The economy might already have been heading for a deeper recession than the NIESR expected. Or perhaps the tax cuts won’t be spent so fast. There is much uncertainty about any forecast. We will see.
A boost to the supply side?
But will the mini-budget boost growth in the longer term? Extra demand in the near term is just inflationary. Only supply-side changes which encourage work and boost productivity can raise growth. Here the news is (generally) good, though the question is whether it is enough to move the macro dial.
Lower NICs and income tax will encourage employment (though not necessarily labour-saving productivity investment). The cut in the top tax rate is particularly encouraging because it will incentivise more people in the finance and professional services sector, as well as entrepreneurs to locate in the UK. It is nice to see a government finally recognize the value of the City. It might even encourage top doctors to keep working! This tax currently collects £6bn but the government reckons that the loss of revenue will be only £2bn because of greater work and less tax avoidance. The IFS agrees though notes that the outcome is highly uncertain and could be anywhere between £0-4bn.
That said, arguably it might have been better to ease the pension and pension contributions caps which deter work and savings. It is not often realized that the big increase in tax on high incomes since the Blair government has come as much from the clamp-down on pension relief as the 45% additional rate of tax. Also, Kwarteng missed the opportunity to smooth the marginal tax rate curve. Families with children can face high marginal rates when they lose the child benefit at incomes over £50k while anyone in the £100-122k bracket faces a tax rate of 60% as the personal allowance is phased out.
The ‘off payroll’ working rules introduced in 2021 for the private sector, known as IR35, are being scrapped. This is a very welcome move and could boost investment and productivity over time. Large businesses will not need to be so careful about how/whether they employ people and it will make the labour market more flexible, encouraging investment.
The cut in stamp duty may make it easier for people to move for a job. But, the eyewatering rates of stamp duty for more expensive houses remain, which make moving house in the South-East of England very unattractive. Again perhaps nitpickingly, it might have been better to have a flat rate of ½% payable on all properties. Low enough so that people hardly notice among all the other expenses of moving but still enough to raise plenty of money.
The cut in corporation tax (from the intended rise) is welcome and should boost growth through higher investment. But that does depend on greater certainty about policy, inflation and Brexit. Also with markets registering uncertainty about economic policy and an election looming it may be optimistic to expect a take-off in investment.
The new Investment Zones are widely expected to move investment around rather than boost it overall. This may be too pessimistic. Some foreign investors may notice an opportunity, especially with the other lower tax rates. This is one of the few measures announced which might not have been possible without Brexit (at least to the same extent – we have yet to see all the details). But of course, Brexit itself makes the UK a less attractive place to invest for many foreign investors.
Kwarteng announced the intention to fast-track many infrastructure projects. With very high inflation in construction costs over the last year achieving much of an acceleration is doubtful. Even if it can be achieved I would tend to put this in the extra stimulus bucket rather than anything that will meaningfully move the macro productivity dial, welcome as it is.
The bottom line? There is no getting away from the fact that this mini-budget is risky for inflation and the public finances. At the same time it is depressing that it only really takes us back a year in terms of the tax take in GDP. (The cut in the standard rate of income tax is offset by the freezing of thresholds, which remains). On the plus side the supply side improvements could make a difference over time. And the government promises more measures in coming weeks. Keep calm and carry on!