The Conservative leadership race is down to the final two candidates. Liz Truss is running on a platform of undoing Rishi Sunak’s tax increases; Rishi Sunak is, unsurprisingly, in favour of maintaining them. This disagreement is quickly taking centre ground in the debate between the two camps, with Sunak insisting any tax cuts would cause inflation and drive up mortgage rates. Truss, meanwhile, believes her policies would increase growth and decrease inflation. They clearly can’t both be right.
Truss has two major tax proposals. The first is reversing the increase in National Insurance rates. This would cost around £13bn per year. The second is cancelling the planned increase in the corporation tax rate, which is currently set to increase from 19% to 25% from April onwards. Government estimates which ignore growth effects put the cost of this cut at £17 billion a year; the IFS expects it the real cost to be “substantially lower” in the long term.
The argument that these cuts would be inflationary runs something like this: if you give people and businesses more money, they’ll spend it. The UK economy doesn’t have a great deal of spare capacity, and any increase in spending means either bringing in resources which would normally be unused, or money chasing supply that can’t expand in response. In both cases, prices go up.
The logic here isn’t terrible, but nor is it entirely correct. The rate of inflation today is best thought of as a combination of economic activity – the channel described above – and expected inflation in the future. Nothing about Truss’ tax policy should alter our expectation of inflation in the very long term; we still expect the Bank of England to stick to its 2% target for inflation. If anything, given Truss’ comments on the Bank’s mandate, we might expect it to become more hawkish in its maintenance.
There’s also nothing in Truss’ policy which suggests a long term deviation from ‘equilibrium’ economic activity. Her policies would probably boost economic growth; they would not cause over or underheating. There is a possibility that they might give greater flexibility in responding to inflationary pressure, but we can probably set that to one side. All we really care about from an inflation point of view is the short-term effect on economic activity.
From this perspective, the first thing to note is that what we care about is aggregate demand. It would be perfectly possible for Truss’ team to offset tax cuts with cuts to spending, leaving demand unchanged. This would result in a shuffling around of prices, but no increase in their overall level. However, it’s possible that she would instead increase borrowing. This would result in demand rising, and create inflationary pressure.
That pressure wouldn’t necessarily translate into inflation, however. The major missing piece here is the Bank of England, and its 2% target. In the event that Truss were to implement tax cuts funded by borrowing, the Bank’s response would follow the usual monetary policy rule: an economy with activity above the usual level and inflation above target means a rise in interest rates, cooling demand, and bringing inflation back towards target.
Fiscal policy changes work faster than interest rate changes, but this policy mix would keep expected future inflation under control, minimising the total effect. This is particularly true when we note that only one of Truss’ tax ‘cuts’ would be reversing a policy that’s already been implemented. The corporation tax increase was announced in March 2022, to take effect in April 2023. It’s possible that a number of projects have been paused between now and then, but the total effect is probably still marginal at this point; we expect a lag between the announcement of a new tax and its impact.
Turning back to how inflation works, the corporation tax cut increases the level of economic activity expected next year. Given that current forecasts are looking pretty bleak, this isn’t something to be overly concerned about. This is particularly true when you remember how companies make decisions: a temporary increase in taxes has a much smaller effect than a hike that people and companies expect to be permanent.
Given that Rishi Sunak was touting tax cuts for businesses last month and government ministers generally have been promising tax cuts in the near future, or at least by 2024, corporate behaviour is likely to have factored future cuts in, making changes in behaviour smaller than they would otherwise be.
This sort of smoothing is harder for households to do. It’s likely that the tax increase in April has affected demand, and that a cut would boost it again. But at this point we can return to the actual size of the cut. The UK government spends somewhere around £1,100bn every year. While £30bn is a lot of money, it’s a very small fraction of this total, and an even smaller part of the UK economy.
There are a number of grounds people can object to Team Truss’ proposals on. They may be worried about distribution. They may have concerns about the public finances. They may believe that corporation tax cuts won’t actually increase growth. But maintaining that these policies are the difference between soaring inflation and prices stabilising is not credible.
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