Sunday, July 24, 2022
Not much headroom for fantasy Tory tax cuts
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission

Yes, I know you are fed up of the Tory leadership contest already but, if I can be allowed one more go, I have a public service to perform. You will be hearing a lot about tax cuts in coming weeks from Rishi Sunak (not now but later) and Liz Truss (both now and later). And you will be hearing, in that context, about the “headroom” for such cuts.

So what is this headroom? Does it exist, and can it be used now? Or is it a version of the sunlit uplands, something that might or might not exist in the future?

The starting point, and stay with me on this, is that the government has fiscal rules, for which it has legislated. The first is that in the third year from now, which happens to be 2024-25, the last year of the current parliament, government debt needs to be falling as a percentage of gross domestic product.

To meet its rules, the government should also only be borrowing to invest by then, which in the jargon means eliminating the current budget deficit; so not borrowing to fund day-to-day spending. There are a couple of other rules, but I won’t detain you with them.

According to the Office for Budget Responsibility (OBR), those rules will be met with room to spare in 2024-25, by £27.8 billion on the debt rule and £31.6 billion on the current deficit rule. There will, in other words, be a current budget surplus of that amount then, on official projections.

Those projections include the 1p cut, to 19p in the pound, in income tax that Sunak announced in his spring statement. They suggest on the face of it that the next prime minister could order his or her chancellor to cut income tax by a further 4p or 5p in the pound, or VAT by 3 or 4 percentage points, just before the next election.

Those are the numbers, but they raise questions. The first is, why wait? Struggling households and businesses would love tax cuts now, not wait for them.
The answer to that is that the headroom does not exist now. The government will still be borrowing for day-to-day spending this year, 2022-23, to the tune of £42.7 billion, within an overall budget deficit of £99.1 billion.

Figures on Thursday, showing public borrowing of £22.9 billion last month, £4.1 billion more than a year earlier and £15.6 billion bigger than the “normal” month of June 2019, suggest that both measures are heading for a significant overshoot compared with the OBR’s forecasts. The public finances are very far from being fixed. Some of this reflects the impact of higher inflation on index-linked gilts, the bill for which will have to be paid in the future.

The second problem is that the headroom only exists because of Sunak’s tax increases. That is why, on the OBR’s projections, a current budget deficit becomes a small surplus next year, 2023-24, and a bigger one in 2024-25. Take away the national insurance increase, the four-year freeze on income tax allowances and thresholds and next April’s increase in corporation tax from 19 to 25 per cent and the rules would be broken I shall come in a second to whether that should matter for a new prime minister.

These are not the only issues. The headroom identified by the official forecaster in 2024-25, roughly £30 billion taking an average between the two calculations, would have been half as much again, if not for the additional cost-of-living help announced by Sunak in recent weeks. It is unlikely that he will ever return as chancellor but his successor, whoever that be, is likely to have to return to this in the autumn, when the cost-of-living squeeze is set to intensify, with a frighteningly large increase in the energy price cap in prospect in October. It would not take many more of these interventions, or as the OBR has warned, further shocks, to use up the headroom, which it says could be wiped out by relatively small changes in the economic outlook.

Not only that, but public services face a further squeeze. The public sector pay settlements announced last week, averaging 5 per cent, will eat into what is left for public services, unless topped up by the government.

Ben Zaranko of the Institute for Fiscal Studies says that this could require “painful” cuts, and a recognition that, in the face of economic shocks there will be less available for public services. Boris Johnson was very keen to avoid the impression that his government was returning to the austerity of the David Cameron/George Osborne years. His “offer” was of more money for public services, paid for in large part by additional taxes on business. Any top up for the public sector, in response to the pay awards, would further eat into the headroom.

Where does this leave us? Many businesses I talk to are hostile to next year’s planned corporation tax increases and would love it to be scrapped. Tax increases are his Achilles’ heel among the Tory membership, but he will hope that what used to be traditional values of fiscal discipline will trump them.

Truss’s unfunded tax cuts are problematical, an almost Pavlovian response to what she thinks Tory members want to hear. There is form on this. Johnson, in his successful leadership bid in 2019, pledged to raise the higher rate threshold – the point at which people start to pay the 40 per cent rate of tax – to £80,000. Even without the pandemic, that was never going to happen.

The affordability of tax cuts is a bigger issue than whether they will add to already-high inflation. They might, but not by much. Truss, who insists she is not modelling herself on Margaret Thatcher, cited the veteran economist Patrick Minford in support of her view that they would not. This brought to mind the time, in 1981, when Thatcher was asked by Michael Foot to name two economists who agreed with her on austerity. She said: “Alan Walters and Patrick Minford.” And, in the car afterwards: “It’s a good job he didn’t ask me to name three.”

As a new prime minister, Truss could rewrite the fiscal rules, or hope that the OBR has been too gloomy, particularly on the balance of the impact of higher inflation of tax revenues, government spending and debt interest. But markets could be very wary, and Citigroup has already warned that her economic approach presents the greatest risk to UK economic stability.

One thing we should be wary of is that there is a promised land of lower taxes ahead of us. Even if the roughly £30 billion of headroom was used to reduce taxes, the tax burden at the end of this parliament would still be the highest in decades. That headroom, as noted, can easily be used by then. It may be a mirage.

The new prime minister has to be honest about this, particularly after the repeated deceptions of the past three years. You can cut taxes, but only if you are prepared to reduce the size of the state or borrow more. Both candidates know this. They need to admit it.