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Tax Cuts, Interest Rises – A Dangerous Premise for Britain’s Budget

The Chancellor ignored the basic laws of arithmetic in this week’s Budget, says Tim Congdon. With economic growth almost at a standstill, unless the deficit is curbed, the debt ratio and interest payments are set to rise, making a mockery of ‘tax cuts’.

A melancholy fact is that, after almost 14 years of continuous and mostly undiluted Conservative rule, economic growth in Britain has come to an almost complete halt. The annual rate of increase in output per head is down to about ½ per cent a year, while many people of working age are leaving the workforce. Against this background, extreme caution in the management of the public finances is essential. If inflation is taken out of the picture by assuming prices are stable, it is obvious that the stagnation of real output requires that the budget be balanced to keep constant the ratio of public debt to national output (or “the debt ratio”). Any deficit – even a very small one relative to national output – will cause the debt ratio to increase.

That proposition is the plainest logic. Admittedly, some increase in the price level is permitted by the current inflation target regime, but the figure is only 2 per cent. No large-scale erosion of the real value of the public debt is possible if this modest inflation target is met, and rightly so. Inflation is an inefficient and dishonest method of enabling governments to pay their way. It taxes citizens because their money is worth less and cheats savers who have bought government debt, as the real value of that debt goes down over time.

It must be emphasized that any deficit has a serious drawback in a nation where economic growth has come to a halt. Any deficit – even a small one – raises not just the debt ratio, but the cost of servicing the debt. The debt interest bill is obviously higher than it would have been without the deficit. Moreover, the obligation to pay the interest is contractual and recurrent. Government spending is permanently higher, again, than it would have been without the deficit…unless action is taken to reduce the debt by running, at least for a period, a budget surplus.

To move from a budget deficit to a surplus of course requires a cut in non-interest expenditure, an increase in taxation or a mixture of the two. And how large must that combination of deficit-reduction measures be for the surplus to be enough that it can restore the original debt-to-national-output ratio? The answer – the indisputable but shocking answer – is that it must be larger than that of the move into deficit. The explanation is not only that deficit must be replaced by the swing into surplus, but that the corrective measures have to eliminate the extra debt interest bill.

The logic of this argument applies even if the deficit occurs only in one year and the correction happens, almost immediately, in the second year. In practice the politicians responsible for the deficit are unlikely to recognise so quickly that they are playing with fire. Suppose that a few years go by, with nothing being done to stop the rot. Then the surge in public expenditure will be even more dramatic because of the interactions between deficits and debt incurrence, and then between debt incurrence and the debt interest bill.

Another twist in the downward spiral comes from the potential reaction of financial markets. As the public finances slide into disarray, with debt interest representing an ever-higher share of expenditure, investors in government bonds are likely to become alarmed. They may fear that the government will prove unable to honour its debts except by levying the inflation tax. To anticipate that outcome, they will require a higher interest rate on any new purchases of debt that they make. They will require it – in other words – on both debt due to the ongoing deficit and debt issued to replace maturing debt. Of course, this process reinforces the remorseless and intolerable expansion of the debt interest bill.

The case for sound finance made in the last few paragraphs is a case not just for a small budget deficit, but for a balanced budget or a budget surplus. The Truss government collapsed in September 2022 because it ignored altogether the laws of arithmetic behind the vicious dynamics of deficit financing. Defenders of that government may say that its unfunded tax cuts would lead to more economic growth and a faster rate of output growth would limit the rise in the ratio of public debt to output. But critics would say this was fantasy. Whatever the rights and wrongs of the argument in theory, the matter was settled in practice by the financial markets. They sold UK government bonds and pushed up their yields, and everyone could see that the implications for future debt interest bills were catastrophic.

The current Chancellor of the Exchequer, Jeremy Hunt, understands very well the importance of maintaining a sustainable trajectory of public sector debt interest. Indeed, the reason he became Chancellor was that his predecessor seemed not to understand the subject at all and therefore had to be replaced. But his latest Budget is presented as if he could forget the constraints that were imposed so brutally on Kwasi Kwarteng and Prime Minister Liz Truss. Tax cuts of £20 billion have been announced, and the surrounding hoopla suggests they are clearly intended to persuade people that this substantial sum is in Mr. Hunt’s gift.

But in reality, the alleged “tax cuts” are an illusion. They are possible only because inflation has forced more workers into higher tax brackets and generated higher tax revenues. Mr. Hunt’s defenders may say that a general election has to be held this year, and that the tax cuts will help the Conservatives at the ballot box. This may or may not be true as a judgement on the political scene, but it is an insult to voters’ intelligence. It is they who produce the output on which tax revenue can be levied, and in that sense the money is theirs and only theirs. It has never belonged to the British government or Mr. Hunt at all.

A responsible Conservative Chancellor would commit to the long-run sustainability of the public finances. With the trend rate of output growth at a low level or even no more than zero, savings on the debt interest bill can be secured only by running budget surpluses or at worst a balanced budget. Mr. Hunt knows this. But he is afraid to tell the truth.  Instead, he has indulged in the disreputable game of trying to bribe the British people with their own money.

Tim Congdon is Founder and Chairman of The Institute of International Monetary Research at the University of Buckingham. He founded Lombard Street Research in 1989, where he was managing director (until 2001) and chief economist (from 2001 to 2005). He also served for five years (1992-97) as a member of the Treasury Panel of Independent Forecasters, the ‘Wise Men’. His books include Central Banking in a Free Society and Keynes, the Keynesians and Monetarism, while his Politeia publications include Inflation: Why Has it Come Back? And What Can Be Done? (2023) and QE for the Eurozone: Sensible, Appropriate, and Well-Calibrated (2015).

Professor Tim Congdon CBE

Tim Congdon is Founder and Chairman of The Institute of International Monetary Research at the University of Buckingham. He founded Lombard Street Research in 1989, where he was managing director (until 2001) and chief economist (from 2001 to 2005). He also served for five years (1992-97) as a member of the Treasury Panel of Independent Forecasters, the ‘Wise Men’. His books include Central Banking in a Free Society and Keynes, the Keynesians and Monetarism, while his Politeia publications include QE for the Eurozone: Sensible, Appropriate, and Well-Calibrated (2015) and Providing for Pensions: Savings in a Free Society (2005).

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