There has been some lively discussion in the media during the past week about what looks like a leak from Downing Street suggesting that taxes will be raised in the Autumn Budget to pay for the costs of coronavirus and the impact of the associated recession.

 

Most of the discussion has been about the politics. Here we try to look through the politics and focus on the economics.

 

The first issue is: does the deficit need to be cut? So called Modern Monetary Theory (actually neither Modern nor Monetary) says no. Our take is that there are two interrelated reasons for keeping the budget deficit in check: the first is to prevent a run on the currency and the second is to prevent inflation.

 

Are these real risks at the moment? While the dollar is the reserve currency and the US Federal Reserve Bank has pumped up the money supply by a fifth in three months, the risk of a falling pound is low in the short term. And although the inflationary signals are mixed, the numbers are fairly low and the price increases that are on the cards are more to do with the one-off costs of providing Covid protection in hairdressers, dentists, restaurants and the like, than signs of an inflationary spiral.

 

We think inflation will rise in 2021 and more likely 2022, but not in the immediate future. So the deficit does not have to be cut immediately but Mr Sunak will probably have to start doing so within a couple of years.

 

Our rough target for sorting out the problem is to aim to reduce the deficit (it doesn’t quite have to reach zero but should be negligible eventually, not least to allow for new emergencies) over 10 years.

 

The debt can be run down more slowly – it took 100 years to bring down the debt from the Napoleonic Wars; while the debt from the two 20th Century world wars was run down more quickly but at the cost of huge inflation which created its own problems. Our take is that running down the debt over 50 years seems like a sensible time period.

 

The second issue is how best to cut the deficit when it becomes necessary.

 

It has been suggested that the taxes that should be raised are corporation tax; capital gains tax and fuel duty.

 

They each have their own issues. The OECD, which is hardly a fire breathing free market think tank, said in its magnum opus on tax a few years ago ‘This paper investigates the design of tax structures to promote economic growth. Corporate taxes are found to be most harmful for growth, followed by personal income taxes, and then consumption taxes. … Recurrent taxes on immovable property appear to have the least impact.’

 

Not only would raising taxes on companies through higher capital gains and corporation tax damage the recovery but they also may not even increase revenue. And it is the UK’s entrepreneurs who have actually been hardest hit by the lockdown and the recession. Now is probably not the time to hit them with a further blow from higher taxes, though if fortunes are made during the recovery it will make sense then to ensure the Treasury gets its share.

 

There is some scope to cut public spending. When Gordon Brown pushed spending up dramatically, the costs rose a lot faster than the services that were being paid for. And so-called austerity cut services rather more than spending. But cutting spending without reducing services means pushing up productivity, which tends to be beyond the capability of modern politicians.

 

But given the limited scope to tax business and to cut spending, we need to face the fact that we all will have to contribute in higher taxes at some point to bring the deficit down.

 

For more information, please contact:

Douglas McWilliams dmcwilliams@cebr.com phone: 07710 083652