Treasury orthodoxy risks strangling growth

Following the financial crisis, Great Recession, Brexit and Covid, the UK needs a fresh economic policy. The imminent establishment of a new Prime Minister provides the opportunity to reset economic policy and galvanise UK competitiveness and its attraction for FDI.

A new research paper from the Centre for Brexit Policy (CBP) argues that HM Treasury’s arguments for higher taxes are defective. The current Treasury orthodoxy of raising taxes to strengthen the public finances and bring down the debt-to-GDP ratio is rooted in outdated lessons from the 1980s when economic conditions were very different to today.

As a result, current policies will lead to lower growth and tax revenues and the debt-to-GDP ratio spiralling upwards to 125 per cent of GDP (from 90% in 2021-22) by the mid 2030s due to: (1) Business taxes reducing economic growth. (2) Higher NICs adding to the drag on competitiveness and output.

Growth risks being undermined by a ‘doom loop’ from the interaction of economic policy with the economy. The rise in taxes is meant to strengthen the public finances but the CBP argues that it will have the opposite effect by destroying growth. Higher taxation, in addition to the gradual defeat of inflation via higher interest rates, and reversing commodity prices, risks a nasty recession and substantially lower growth in the long run.

HM Treasury wants to raise taxes to reduce the post Covid budget deficit. But higher taxation reduces the incentive for entrepreneurship, and thereby lowers consumption, investment and GDP growth. The end result will be a higher numerator and lower denominator for the public debt to GDP ratio, because of the supply-side damage to the economy. In the tax realm, as everywhere, actions have consequences. If you tax something, there will be less of it.

We need to boost the supply-side attractiveness of the UK economy. The only decade in the past 50 years when dramatic supply-side policy changes were implemented was the 1980s. And no surprises for guessing which decade in the past 50 years achieved the fastest GDP growth. The average growth rate in the 1980s was 2.8%, compared with 1.7% in the 2010s.

So, what does the reset look like?

Tax rates should be set to maximise growth over the long run. The UK needs a tax system for the 21st century that delivers stable revenues without penalising either saving or incentives for successful people. At present the tax system contains a mass of high marginal tax rates, such as the 45% additional rate and the withdrawal of the personal allowance (losing £1 of personal allowance for every £2 of income above £100,000) which creates a 60% marginal tax rate.

That HM Treasury seems in no hurry whatsoever to address this glaring deficiency in the tax system (in place since 2010) speaks volumes as to its lack of concern over the negative supply-side consequences of taxation.

The other pillars of supply-side policy reform are trade liberalisation and deregulation. The more we pursue these post-Brexit, the greater will be the economic benefit. With regard to trade agreements, we need to sign so many deals it has the effect of unilateral free trade and brings down UK prices to world levels. According to the GTAP trade model – used by HM Treasury – this could bring long-term gains of 4% of GDP via lower prices to consumers and competition led productivity increases by UK producers.

Modelling by Professor Patrick Minford (in the CBP paper) suggests the gain would be doubled if we simply abolished half the EU level of protection still in place. Astonishingly, the Treasury believes the gains from free trade will be only 0.2% of GDP on the grounds that this policy will barely be carried out – despite it being stated Government policy. Moreover, the Treasury also assumes that post-Brexit, ‘new’ trade barriers costing 5% of GDP will emerge over the UK-EU border, even though these would be illegal under WTO rules.

EU Law has been transposed into UK law and the new Prime Minister needs to begin taking a scythe to it. There is a huge opportunity to boost Britain’s competitiveness by reducing product and labour market, environmental and City related red tape.

According to CBP modelling ‘business as usual’ fiscal policy results in the public debt to GDP ratio reaching 70% of GDP by 2029-30 and 125% by 2034-35. In contrast, the Liz Truss announced reversal in Corporation Tax and NICs, and delay of the environmental levy, result in the debt ratio falling to 63% by 2029-30 and 52% by 2034-35.

Most exciting though is the potential supply-side consequences of a £100 billion fiscal stimulus package (cutting corporation tax by 10%, abolishing the 5% additional income tax rate, cutting the top rate of income tax to 30% and the standard rate by 5%). Assuming constant spending, this reduces the debt ratio to less than 70% within 5 years and 50% before the end of the decade. It also raises the prospect of a potential budget surplus early in the 2030s, which would enable even deeper tax cuts and a further supply-side boost to potential growth. What a prize. The new Prime Minister needs to reflect that for those to whom much has been given, much is expected.

Professor Graeme Leach holds the visiting professorial chair in economic policy at the University of Lincoln.