A mini-budget it was not. The first fiscal statement from the Conservative government of Liz Truss, freshly installed as Prime Minister of the United Kingdom, had not been expected to add up to much. Instead, the plan unveiled Friday by rookie Chancellor of the Exchequer Kwasi Kwarteng turned out to be surprisingly radical, a mix of sweeping tax cuts and microeconomic reforms aimed at boosting Britain’s chronically sluggish long-term growth rate.
Suffice to say the reviews have not been kind. The pound dropped nearly five per cent against the U.S. dollar on the day the plan was released. Interest rates on British government bonds jumped almost a full percentage point. An opinion poll taken shortly afterward put the Labour Party 17 points ahead of the Conservatives.
Market reaction to the plan was mainly driven by the sharp deterioration in Britain’s fiscal position it seemed to signal – though the plan itself does not include any projections for the country’s deficit and debt. That did not prevent outside observers from making their own forecasts, and at first blush they are genuinely alarming.
Instead of declining from 4 per cent of GDP to 1 per cent over the next couple of years, as the government had projected in March, the deficit will rise to more than 7 per cent of GDP this year, according to the Institute for Fiscal Studies, and remain above 3 per cent of GDP for years to come. The debt will likewise increase from an already nosebleedy 83 per cent of GDP to nearly 95 per cent four years out.
(This may or may not reflect the government’s actual plans, however. Along with the failure to include projections for the deficit, the plan also neglects to make any proposals for spending cuts. Yet it pledges to keep the debt-to-GDP ratio falling – including by “keeping spending under control.” We shall see what that means.)
In the media and political worlds, however, more attention was focused on the proposal to cut the top marginal rate of income tax from 45 to 40 per cent. The objections were three: that it was unaffordable, that it was unfair, and that it would not work even in its stated aim of boosting investment.
The first is the most easily disposed of. The cut in the top rate is but one of several tax cuts in the plan, and by far the least expensive: of the average £126-billion deficit over the next five years, it is expected to contribute less than £2-billion annually. Compare the cost of cancelling a planned increase in the corporate tax rate (about £14-billion annually), or the reversal of a 1.25 percentage point increase in National Insurance contributions imposed earlier this year (£15-billion).
Any cut in the top rate of tax obviously benefits only those in a position to pay it, which is enough to condemn it on its own, in some eyes. But it’s hard to see exactly on what basis. The measure of a fair tax system, after all, is that it should be progressive – the rich should pay a higher proportion of their income in tax than the poor.
Very well: the British tax system is progressive now – the top 1 per cent of income tax payers earn about 13 per cent all income in the U.K., but pay 28 per cent of all income tax – and it will still be progressive after. Indeed, the last time the top rate was cut, from 50 to 45 per cent, the share paid by the top 1 per cent rose, from 25 per cent to 28 per cent.
Changes in tax rates, it turns out, induce changes in behaviour. Not only do people have more incentive to earn income at lower rates of tax, but also to declare more: it’s no longer worth going to as much trouble and expense to look for tax loopholes.
From a growth standpoint, the first is obviously more important. The reason why cuts in tax rates might be expected, other things being equal, to lead to higher rates of investment has less to do with ideology than arithmetic.
Suppose you need a 10 per cent rate of return after tax to justify investing the marginal dollar, rather than spending it. At a 50 per cent marginal tax rate, an investment would have to return 20 per cent before tax to pass that test. But cut the tax rate to 33 per cent, and it would only need to pay 15 per cent. In other words, all those investments paying between 15 to 20 per cent that were uneconomic at a 50 per cent rate of tax become economic at 33 per cent.
A cut from 45 to 40 per cent would obviously not be so dramatic in its effect. But to quote an old economic saying, every little bit helps.