For 12 years fiscal probity has been the cornerstone of the Conservatives’ economic strategy. Not anymore. At his so-called mini-Budget on 23 September Kwasi Kwarteng, the Chancellor, abandoned his party’s old focus on the deficit and instead slashed taxes as part of a “Plan for Growth”. But just as the government is pushing its foot down on the accelerator, the Bank of England is slamming on the brakes. The risk is that policymakers lose control of the car.
It is hard to overstate just how significant a volte-face Kwarteng’s fiscal statement was. The largesse was of such a scale that the government’s radical move to cap energy prices for households and businesses – expected to cost £60bn for the next six months alone – was almost entirely overshadowed by its tax changes. Markets and analysts had been expecting tax cuts worth around £30bn, with the planned rise in corporation tax from 19 per cent to 25 per cent being scrapped and the rise in National Insurance in April being reversed. Kwarteng went much further. He cut stamp duty, reduced the basic rate of income tax from 20p to 19p and, in a move almost no analysts saw coming, abolished the 45p tax rate on earnings over £150,000. In total the tax take is now set to be around £45bn lower, a permanent cut in revenues worth about 1.5 per cent of national income.
That represents the biggest set of tax cuts since 1972, which is an uncomfortable precedent for the government. Back then Anthony Barber, the chancellor in Ted Heath’s Conservative government, was faced, like today’s ministers, with a troubling combination of high inflation and stagnant growth. His answer was the “dash for growth”, an attempt to stimulate economic activity by cutting taxes. The resulting “Barber boom”, however, proved short-lived and was quickly followed by bust and ever higher inflation. Fifty years on it is widely regarded as perhaps the worst postwar British Budget.
Kwarteng rejects this comparison. The tax cuts, according to him, are not about stimulating demand but about improving the supply side of the economy. By lowering taxes on work and profits he hopes to encourage households to work harder and companies to invest more. The evidence for such effects is, to be extremely generous, debatable. More importantly, even if tax cuts are capable of improving the supply side of the economy, the time taken for such improvements to show is usually measured in years rather than months. In the short term, the main effect of the tax cuts will be to inject more money into the economy.
At exactly the time at which the government has decided to increase support for demand and near-term growth, the Bank of England is moving in the opposite direction. Inflation stands at 9.9 per cent and while that reflects high global energy prices, core inflation (which excludes volatile components such as energy and food) is running at an annual rate of 6.3 per cent. In the Bank’s view this is being driven by an overheating domestic economy and a very tight jobs market. The Bank has already increased interest rates from 0.1 per cent last December to 2.25 per cent, its fastest pace for three decades, to try to restrain demand and inflation, even while forecasting a recession. It is hard to avoid the conclusion that the Bank has decided a downturn is necessary to return inflation to the 2 per cent target. In other words, what the government gives via tax rates will be offset by the Bank moving interest rates. In the aftermath of the Chancellor’s statement, financial markets priced in a base rate by next summer of over 5.5 per cent – a level not seen since before the 2008 crash. Economic policy appears to be entirely uncoordinated.
Unsurprisingly, financial markets have been rattled. The pound tanked in the immediate aftermath of the Chancellor’s statement and continued to fall in trading today to just $1.07. The yield on gilts, the interest rate on the government’s own debt, recorded its largest daily rise since the early 1990s and two-year bonds now stand at 4.56 per cent (compared with 1.7 per cent at the start of August). Talk of an emergency Bank of England rate rise to steady the value of the pound is spreading across trading floors. Even the older hands cannot remember so negative a reaction to a British Budget.
While the volatility in the pound is occupying the headlines, it is the move in interest rates which is of greater concern. Higher rates not only mean that the cost of the government’s new borrowing will rise but that households face a potentially disastrous squeeze. A base rate of over 5 per cent would mean monthly mortgage payments for many borrowers leaping by hundreds of pounds. A significant house price crash would probably follow.
So what happens next? The Truss government is maintaining a brave face publicly about the market reaction; indeed Kwarteng used the weekend to declare his intention to cut taxes further next year. But privately it is hard to imagine ministers are not spooked. As interest rates rise they will be forced to take action to reduce the government’s borrowing. Admitting that the tax cuts were too great would be a U-turn too far. Instead a more likely cause of action will be to unveil spending cuts – public sector pay freezes, welfare cuts and capital spending reductions – and claim that this was always part of the plan.
The UK risks stumbling into the worst of all possible outcomes for short-term growth, with the government effectively taking money from those most likely to spend it (welfare recipients) to fund tax cuts for those most likely to save it. All amid a backdrop of a weaker pound, which raises the cost of imports, and higher interest rates, which slow growth further. Like Barber’s Budget in 1972, Kwarteng’s far from “mini” version risks becoming a cautionary tale.
[See also: Has the Bank of England lost control?]