The Chancellor’s decision to raise corporation tax may help arrest a spiralling deficit. But, says Tim Congdon CBE, it sits uneasily with his hand outs to foreign companies.
Scare stories about public finances are easy to put together and narrate. For the sake of illustration, consider a nation in which both public expenditure and gross domestic product are given and unchanging in nominal terms. Further, take it that in this nation tax revenues are slightly less than public expenditure, resulting in a budget deficit of, say, 2 per cent of GDP. This sounds modest and manageable relative to the UK today, where the budget deficit in the current 2022/23 fiscal year has been running at about 7 per cent of GDP.
But it is obvious that – given the assumptions – the nation with a 2-per-cent-of-GDP budget deficit is in a totally unsustainable situation. Remember that nominal GDP is not rising at all. Then the deficit of 2 per cent of GDP in year one adds to the public debt. Interest has to be paid on the debt, and in year two both debt interest and total public expenditure are higher than in year one, and so is the budget deficit. So the growth of the debt is higher in year two than in year one. In year three both debt interest and total public expenditure are higher than in year two, and so is the budget deficit. So the growth of the debt is higher in year three than in year two.
And so on. Starting from an apparently modest budget deficit, the interactions between the deficits and the debt, and then between the debt and interest payments on it, cause the public debt to explode. The debt interest bill becomes a Frankenstein monster with a life of its own which wrecks the public finances. Unless something changes, the ratio of debt to GDP climbs without limit.
Readers will immediately object that the example is unrealistic, because in practice nominal GDP is always increasing and the rise in nominal GDP prevents the ratio of debt to GDP taking off into the stratosphere. But we need to remember the numbers here. Nominal GDP increases partly because of extra real output and party because of increases in the price level due to inflation. How much help can we expect from these sources in the next few years?
As far as real output growth is concerned, it depends on future trends in the number of people employed and in output per head (also known as “productivity”). Employment will be held back in the next few decades as the baby boomer generation retires. Young people are not entering the workforce in large enough numbers to outweigh the negative effect of old people leaving it, while immigration is politically unpopular.
If the UK were enjoying buoyant productivity growth because of new technologies and rising efficiency, the demographic constraintmight be overcome. But the melancholy fact is that in the 13 years 2007 to 2019 inclusive – for the period of the Great Recession and later, and before the damage from Covid – output per head rose in the UK by a mere 0.5 per cent a year. Arguably. the trend annual growth rate of UK real output at present is no more than 1 per cent. The Office for Budget Responsibility is reported in the 2023 Budget documents as expecting output per head to increase by 1 per cent a year or more in each of the four years 2024 – 27 inclusive, after much weaker numbers in 2022 and 2023. The OBR may be right, but it is optimistic relative to the recent past.
Inflation was on average 2 per cent a year in the decade to 2020, exactly in line with a target set in 2003. Although inflation has been in double digits in recent months, the Bank of England’s central task is to restore the 2 per cent inflation rate. Let us conjecture that the current monetary tightening will work, and that over the medium term performance will improve and the target will again be met. Then – with the 1 per cent real output growth as well – the growth rate of nominal GDP to be envisaged over the medium term is a mere 3 per cent.
As net public debt stands at about £2,500 billion and is roughly equal to GDP, a deficit of 7 per cent of GDP is certain to raise the ratio of debt to GDP. The Chancellor has no choice. He has to take whatever action is necessary to bring the deficit closer to 3 per cent of GDP. Even better, if he could limit it to only 1 or 2 per cent of GDP, there might even be a chance of lowering the ratio of debt to GDP. Moreover, if public expenditure cannot be reduced relative to GDP, the arithmetic is inexorable and vicious. To contain the Frankenstein of debt interest and to stop the debt rising relative to GDP, taxes must go up.
In today’s Budget Jeremy Hunt, the Chancellor of the Exchequer, upset many people in the business world by raising the standard rate of corporation tax from 19 per cent to 25 per cent. But he had to do something about the public finances. Who can overlook that Hunt became Chancellor last year only because the Kwarteng Budget on 23 September was a fiasco? The unfunded tax cuts in that Budget were so big as to risk a slide into ever-increasing deficits. Financial markets were not fooled by Kwarteng’s supply-sider rhetoric. Investors sold off gilt-edged securities and pushed up their yields. The increase in yields added another twist to the upward spiral in the UK’s future debt interest bills. The Budget documents show that in 2020/21 debt interest was only 2 per cent of the government’s tax revenue. By contrast, in 2022/23 it will have quintupled, to a shocking 10 per cent of revenue. That is a measure of the challenge confronting the government in this area of public policy.
By the 2024/25 fiscal year the extra revenue from corporation tax will reduce the deficit by about 1 per cent of GDP, while other planned tax measures cut it by another 1 per cent of GDP. These may sound like insignificant amounts in the life of a great nation, but – to repeat – Jeremy Hunt had no choice. With the national debt at roughly the same size as GDP, an increase of 1 per cent (100 basis points) in the interest rate on the debt therefore implies extra public expenditure also of 1 per cent of GDP. Keeping the trust of potential investors in British government debt is critical to long-run fiscal sustainability.
Would it be worthwhile to have another look at public expenditure? In particular, is there a case for cutting back on subsidies to foreign companies? According to recent newspaper stories, Tata Motors – the owner of the Land Rover car business – has “demanded” £500 million of government funds for locating an electric vehicle battery factory in the UK. Tata has apparently been offered financial support by Spain if it built the factory there. One report spoke of the Indian firm delivering an “ultimatum” at an allegedly “pivotal moment” for the UK car industry. It seems that last year Tata had almost committed to a battery factory in Somerset, in association with its Chinese production partner Envision, but had deferred a final decision until the government had also given the green light for a subsidy to its steel plants.
Separately, Orsted – a Danish company, with the Danish government a major shareholder -has threatened to shelve a £8 billion project for the world’s biggest offshore wind farm, unless it receives newly generous tax treatment for its investment. Orsted’s complaint is that construction costs have risen sharply in the last year, while financing costs have jumped because of the increase in interest rates. Without a special tax break, the project cannot make a profit. If the tax break is not granted, presumably meaning a loss to the government of several hundred million of pounds, the turbines will not be erected 75 miles off the Norfolk coast.
Tata and Orsted may not receive all the money they are “demanding” from the British state, but the signs are that they will pick up enough to make a dent in the 2023/24 and 2024/25 budget numbers. Further, if Tata and Orsted are viewed as deserving supplicants, what is to stop other foreign companies knocking on the government’s door to help with their loss-makers? (Yet another newspaper report in this vein is of BMW “revving up” a £500 million plan to maintain Mini production at Cowley, but only because the government has chipped in a £75 million grant.The £75 million comes from an Automotive Transformation Fund, which is presumably many times larger and is said by Sky Television to have “been signed off by the Chancellor”.)
Should the government increase taxation on British companies in order to pay large sums to foreign companies? The question may seem silly. Of course, the government should avoid taxation of this sort, not least because in many cases the British and foreign companies are competitors. However, all too often in modern Britain, politicians and civil servants lose the plot and do things that are against the national interest. Do they not understand that the larger the hand-outs they give to foreign companies, the more revenue they will have to raise from British taxpayers, including the British companies now confronted by a corporation tax rate of 25 per cent? Chucking money at foreigners mocks the very notion of an “industrial strategy” to benefit our own country.