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July 24, 2022

The Telegraph – How low can they go? The bidding war defining the Tory leadership race

The race to become Britain’s next prime minister has become a bidding war over how far each candidate will go with tax cuts, as the country suffers in the wake of the pandemic.

Rishi Sunak, the former chancellor, has accused Liz Truss of irresponsible, “socialist” plans to borrow more to fund tax cuts. In turn Truss, the Foreign Secretary, said her rival has set Britain on course for recession with higher taxes. 

In a contest already marred by “dirty tricks” and blue-on-blue brutality, the claims threaten to seriously harm each of the two contenders before either even steps inside Number 10.

Both are promising vastly different economic policies, throwing up the question of which is correct for Britain.

As she launched her campaign, Truss, the favourite in polls of Tory members, said: “Under my leadership, I would start cutting taxes from day one to take immediate action to help people deal with the cost of living.”

That means cancelling next year’s planned hike in corporation tax, reversing April’s national insurance raid on pay packets and offering tax breaks for those who take time out of work to care for relatives.

This parks her tanks firmly on the lawn of Sunak, the candidate with the most support from Conservative MPs. He called her plans a “fairytale”, arguing it would mean higher borrowing and inflation rather than responsible stewardship of the economy.

The former analyst for Goldman Sachs has long promised taxes will eventually come down, but only after repairing some of the damage wrought on the public finances by the pandemic.

This has to wait until inflation, currently at its highest in 40 years, slows down, for fear of worsening the cost of living crisis. “We have to be honest. Borrowing your way out of inflation isn’t a plan, it’s a fairytale,” he said in a TV debate.

When the next prime minister begins their tenure on Sep 5, how much room will they have to cut taxes – and would doing so help or harm the economy?

The first question is how much fiscal space there is to cut.

At the time of Sunak’s Spring Statement in March, the Office for Budget Responsibility (OBR) estimated the chancellor would hit his borrowing targets in the middle of this decade with around £30bn to spare.

On the face of things, Truss’s plans would soak up that entire headroom and more. The Institute for Fiscal Studies estimates her tax cuts would come in at somewhere above £30bn, and she also wants to spend more in areas like defence.

While that would appear to break the fiscal rules that have been set, conditions have changed since March.

Sunak offered more funds to help households with the cost of living crisis, so those close to him note there is little left for Truss to dish out.

Meanwhile, inflation has been worsening. When the forecasts were made, officials thought price rises would peak in the autumn at 8.7pc. CPI has already exceeded that and could rise above 11pc.

The OBR also thought the Bank of England would raise interest rates no higher than 1.9pc, but the battle against inflation is so tough that financial markets now expect Threadneedle Street to go to 2.75pc by the end of the year and higher into 2023.

These both put pressure on the Government via higher borrowing costs – in June alone the debt interest bill hit £19.4bn, hammering the public finances.

Samuel Tombs, at Pantheon Macroeconomics, estimates the headroom has already been cut in half.

“Spare borrowing capacity of £15bn is too meagre to finance the plans proposed by Ms Truss,” he says. “The next Prime Minister probably won’t be able to both cut taxes meaningfully and stick to the existing fiscal rules.”

However, even as inflation adds to Government costs, including debt interest and the triple-locked state pension, it also brings in more cash for the state’s coffers.

When prices rise, the Treasury rakes in more VAT. As inflation takes hold, workers push for higher pay rises. These are not so far keeping up with the cost of living but are expected to rise more quickly than Sunak anticipated when he froze the income tax thresholds, making for a spectacularly lucrative stealth tax.

Douglas McWilliams, at the Centre for Economics and Business Research, expects the public finances to get a £60bn boost from inflation by 2024-25, even after accounting for higher Government costs – taking the headroom to around £90bn.

That would give Truss more space for tax cuts, or at least to reverse some of the tax rises. An alternative is to change or scrap the borrowing targets: there is no requirement for a Truss government to honour targets set by Sunak under Boris Johnson, though Truss’s spokesman says there are “no plans to change the UK’s current fiscal rules”.

Gerard Lyons, a former economic adviser to Johnson now at Netwealth, says it would be better to “go for growth” and “not be constrained by arbitrary fiscal rules which in the past have always been discarded at the first sign of any difficulty.”

“Fiscal rules are a complete nonsense,” he adds.

“The only fiscal aim should be to reduce debt to GDP steadily over time. There is fiscal space. How much naturally depends on your assumptions about growth, which leads to how you think [tax] changes can impact the economic outlook.”

But even if it is possible – is it wise? 

Sunak says tax cuts risk raising inflation and making the situation worse. He does not plan any personal tax cuts until inflation is back under control.

Britain is certainly on the brink of a recession. The Bank expects GDP to go into reverse later this year, shrinking when bills jump in the autumn and pay packets fail to keep up.

Truss, meanwhile, argues lower taxes will ease the pressure from the cost of living crisis and help support an economy at risk of recession.

She says she opposed the National Insurance hike which came into force in April, taking an extra 1.25 percentage points from workers’ pay packets and the same again from their employers – a levy planned before inflation really took off but not cancelled or postponed once the pain became clear.

Lyons says “timely, targeted tax cuts” are “the correct response” to this type of economic squeeze when demand needs support.

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