Cutting taxes will not magically improve the UK’s economic performance

Whatever happens in the wake of Boris Johnson’s announcement that he will resign as prime minister, the immediate question for a Conservative government, and for the current chancellor, Nadhim Zahawi, is whether to cut taxes. The mood on the Tory backbenches is favourable, with many saying the UK’s poor growth prospects are linked to high levels of taxation. The question of what level of taxation is right for the UK economy is simultaneously both simple and difficult to answer.

Let us take the facts first. The burden of UK taxation is rising from 33 per cent of national income to a planned 36.3 per cent in 2026-27, according to the Office for Budget Responsibility’s spring forecasts. This is the highest since the late 1940s. The government planned to use the rising tax burden in three ways: to improve the public finances; to pay for new public services such as the proposed cap on social care costs; and to pay for some of the longer-term consequences of the Covid-19 pandemic.

The first easy response to the calls for tax cuts is to dismiss these as inflationary. Interest rates are no longer at zero and lower taxes aimed at boosting household and corporate spending would create excess demand and even higher prices. The Bank of England controls the balance between aggregate demand and supply, so if government pumps the former up with a sugar rush of tax cuts, the central bank will need to offset this with higher interest rates.

In the past week, Andrew Bailey, BoE governor, his deputy, Jon Cunliffe and his chief economist, Huw Pill have all stressed the need to get inflation down. They recognise that a period of weak economic performance with higher unemployment is necessary and a government that tries to avoid this fate will end up with either higher inflation or higher interest rates.

The second easy counter to a demand for tax cuts is to highlight that higher taxes are not the reason for the UK’s poor economic prospects. The nation is at full employment even with fewer people in the labour force than hoped, so it is productivity improvements that are necessary for sustainable economic growth. Lowering personal taxes does not create more efficient companies.

However, another part of the answer, which might trump the two simple points above, is that if the current tax system is collecting too much money and raising the tax burden too quickly, rates of tax could be cut without boosting demand excessively.

Rishi Sunak’s decision to freeze income tax thresholds, for example, was supposed to raise £3.7bn next year. But in March the OBR thought that higher than expected inflation would raise that figure to £10.4bn. This is just one example of inflation providing a short term and unexpected boost to the public finances. With inflation prospects even higher now, the tax system is potentially doing more work in collecting revenue than necessary.

The Treasury could easily give back this unexpected windfall without jeopardising its medium-term prudence on the public finances. Never forget, though, that this is not a genuine tax cut, but merely restoring the size of the planned tax increase rather than permitting additional fiscal drag.

In his resignation letter, Sunak correctly said, “our people know that if something is too good to be true then it’s not true”. That is the difficult reality facing any new chancellor.

The UK tax burden needs to rise unless a government is willing to scale back the quality and quantity of public services. Rising energy prices make the country poorer and all government can do is redistribute these losses as fairly and efficiently as possible. And cutting taxes does not magically boost economic performance.

Any politician suggesting otherwise is lying to you.

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