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Osborne's new tax cutting agenda could mean even bigger spending cuts

The Chancellor's new assumption that tax cuts significantly boost growth could result in a higher than expected deficit. 

The Chancellor's approach could result in a higher than expected deficit.
George Osborne during a visit to the Royal Mint on March 25, 2014 in Llantrisant, Wales. Photograph: Getty Images.

For years, George Osborne has opposed what he describes as "unfunded tax cuts": those that are not paid for by a tax rise or a spending cut elsewhere. As recently as February 2013, he told the US-based Manhattan Institute:

I am more of a Thatcherite than a Reaganite when it comes to tax policy...I'm a fiscal conservative and I don't want to take risks with my public finances on an assumption that we are at some point in the Laffer curve. What I would say is let's see the proof in the pudding, in other words. I'm a low tax conservative, I want to reduce taxes but I basically think you have to do the hard work of reducing the cost of government to pay for those lower taxes.

It is a stance that has long dismayed his party's Lafferites. But in a break with his past position, Osborne has now embraced "dynamic scoring": a model favoured by the US right which purports to measure the full effect of tax cuts on the economy, rather than merely the "static" cost to the Treasury. The aim is to demonstrate that tax cuts are possible even in times of fiscal constraint (the deficit was forecast to be £108bn in 2013-14) due to the beneficial impact that they have on growth.

Osborne will today publish new Treasury research suggesting that the 20 per cent real-terms reduction in fuel duty since 2011 is likely to generate enough growth to cover around half of the lost revenue (having previously published a similar study on corporation tax). According to the paper, tax cuts of this level will boost output by up to 0.5 per cent of GDP (£7.5bn) over the next two decades by encouraging people to drive more and stimulating consumption and investment. During his recent appearance at the Treasury select committee, Osborne said: "I’m not expecting some overnight change in the way Parliament and the Treasury does public finances but I think it will start this quiet revolution where people come to realise that if you leave more money in people’s pockets they tend to be better at spending it and investing it than government."

But among those sceptical of Osborne's "quiet revolution" is the Office for Budget Responsibility, the fiscal watchdog he founded in 2010, which has steadfastly refused to embrace the model. This is because, as the FT's Chris Giles notes, the Treasury research relies on some generous assumptions. For instance, "that the cost of the fuel duty cuts not offset by other increased revenues is paid for by the imposition of a pure poll tax, paid equally by every household regardless of income."

As Giles notes, "Had the Treasury used more realistic offsetting tax increases, its results would show the fuel tax cuts raised growth by less and the offsetting revenue growth would have been smaller." In addition, the research ignores the negative economic effects of cutting fuel duty such as increased congestion and pollution on the grounds that they are too difficult to measure. 

It's for this reason that the oracle of economics, the Institute for Fiscal Studies, warns that "You have to wait 20 years before you get the full response if the model is correct. Clearly there are risks there and a lot of uncertainties". The danger is that Osborne, seeking to woo the Conservative right (whose support he will need in any future leadership contest), banks the anticipated revenue from the fuel duty tax cuts, leaving the government exposed if it fails to materialise. And should the deficit prove larger than expected, there is little doubt that the Chancellor will rely on spending cuts, rather than tax increases (which he has promised to avoid), to plug the gap.