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13 July 2022

Tory leadership candidates’ zeal for tax cuts could cost the UK billions

Conservative contenders are forgetting that the government stimulates the economy by spending.

By Will Dunn

The race to replace Boris Johnson as Prime Minister has become a race to see who can cut the most tax. Jeremy Hunt says he wants to “cut all taxes”; Liz Truss has promised to “start cutting taxes from day one”; Sajid Javid stated how he thought tax cuts were “a prerequisite for growth”, before he dropped out; and the front-runner, Rishi Sunak, has pledged to act quickly to cut the taxes imposed by the previous chancellor, Rishi Sunak.

The UK’s “tax burden”, as it’s being called, is predicted to hit its highest level since the 1940s (at 36.2 per cent of GDP, according to the Office for Budget Responsibility) by 2026-27. The Conservative response to this will be to appoint a new prime minister to slay the tax dragon, whereupon the soil of Britain’s economy shall be soaked with the grateful tears of Hard Working Families, and the green shoots of recovery shall spring forth. 

Or shall they? For one thing, the UK’s tax-to-GDP ratio – the amount it takes compared with its GDP – is relatively small: even assuming all current and planned tax rises, it will still be lower than that of Germany, Norway, Canada and, indeed, most Western countries. This suggests that “Sunak’s tax raid”, as the Telegraph has called it, isn’t the reason the UK is predicted to have the lowest growth in the G7.    

More importantly, tax cuts do not pay for themselves: they come at a huge cost. 

According to the Institute for Fiscal Studies (IFS), reversing the 1.25 per cent National Insurance increase would cost £13bn per year, and reversing the 1.25 per cent rise in dividend tax rates would cost an extra £1bn per year. Moving the 1 per cent income tax cut forward a year to 2023-24 would cost £6bn (and another £6bn on top of that if moved to this autumn).

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The most expensive tax cut, promised by Hunt and, before he pulled out, Javid, would be to reduce corporation tax to 15 per cent, the minimum floor agreed by 138 countries last year. (Hunt said he would do this all in one go.) The IFS says the foregone tax alone would cost £31bn a year.

But tax cuts are even more costly than that, because the very effect the Conservative hopefuls promise they will have – to boost spending – is inflationary. “If you’re doing anything that stimulates spending at a time of full employment, and also at a time where the supply side of the economy is constrained, that will tend to be inflationary,” explained Jagjit Chadha, director of the National Institute of Economic and Social Research (NIESR). 

Because the Bank of England has a remit to control inflation, any “inflationary impulse” created by a tax cut means the Bank will have to raise interest rates in response. This creates an even bigger cost: “We’ve got £800bn of debt that is serviced directly at Bank rate,” Chadha continued, which becomes “immediately more expensive” when interest rates rise. One percentage point added to interest rates immediately adds £8bn-£10bn to the cost of servicing government debt, he added, which carries a final cost of around £20bn.

Conservative politicians might not mind this extra cost, because it allows the blame for economic damage to be shifted from the government to the Bank of England with its pesky interest rates. But for the rest of us, spending tens of billions of pounds making the government look better during a recession is, frankly, a lot to ask. 

[See also: The Tory leadership candidates are desperately short of new ideas]

But this is far from the only unintended side effect of slashing taxes. When Gordon Brown reduced corporate tax rates in 2002, the main effect was to prompt thousands of self-employed people to set up companies to lower the amount of tax they paid. “It was just crazy. The number of companies just shot through the roof,” recalled the tax expert Richard Murphy. There are an estimated five million self-employed people in the UK who could save on their tax bill by declaring their income through a company (entirely legally, and within the IR35 rule), and Murphy said the practice could extend to people with unearned income to declare, such as landlords.

This could represent a huge, and apparently uncosted, cut from income tax, the government’s most important source of income. And remember, if that money is spent by people on goods and services, it’ll increase demand and add to inflation.  

What’s particularly maddening about the corporate tax cut is that businesses don’t even want it. Alex Dunnagan, researcher at TaxWatch, pointed out that of the two million actively trading companies in the UK, nearly half a million paid no corporation tax in 2018-19, and more than a million had a liability of less than £10,000. Murphy said small businesses have significant problems with business rates, VAT and employers’ National Insurance, but corporation tax is “a non-issue”.

If multinational companies were going to flock for the benefit of low corporation tax they would have done so already, because the UK already has a low rate of corporation tax. Other countries charge both federal and regional corporation taxes, which add up in most cases to much higher rates than Britain. Even after the government’s planned rise to 25 per cent (for businesses declaring more than £250,000 in profit) the UK would still tax these companies less than the US, Germany, Japan or France, contrary to claims made by Hunt.

It gets even more stupid. Last year, we agreed with 137 other countries not to reduce our effective tax rate (the average of what businesses actually pay, after reliefs, exemptions, etc) below 15 per cent. What Javid and Hunt are proposing is to reduce the headline rate (what the government asks businesses to pay), which is always higher (the government currently asks for 19 per cent and gets 16.8 per cent). When we break that tax floor, the OECD’s Undertaxed Payments Rule will allow other OECD countries to collect the difference themselves. Multinational companies will have zero incentive to move to the UK, and other countries will be able to tax profits made within our borders. Perhaps all the other countries will be so busy laughing that they’ll never declare war? 

Perhaps the most difficult cost to calculate, however, is the cost of reducing public spending. Since 2010, the Conservative Party has pretended that “UK plc” is effectively another business that can save money by sacking people, but this isn’t the case: it is by spending more that the government stimulates the economy. As Murphy put it: “It is the biggest single participant in our economy… They are the driving force and the creator of the money supply, they have a duty to be an active participant.” 

Dunnagan suggested that a Conservative candidate who wants to talk about the “tax gap” – the £32bn in tax that went uncollected last year, not including the tax avoided by multinational profit shifting. “I think that’s something that resonates with the public… The numbers are massive.”

But for Chadha, the leadership contest shows a disturbing willingness to ignore difficult problems and make decisions vital to the economy on the basis of what will play well with a handful of voters. “People are talking to a very small fraction of the electorate and making promises that in many cases haven’t been costed and may not be sustainable, given the level of public debt. It seems to me [a] very strange way to run fiscal affairs.”

[See also: Why are the Tory leadership candidates not talking about NHS waiting lists?]

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