Tax cuts are centre stage in the Conservative leadership debate. To the outside world it may appear that the Party is in a bidding war to see who can lower taxes the most. Yet the Government has been embarking upon a policy of tax hikes covering a plethora of areas.Since the December 2019 election, it has been a case of watching what the Government does, not just listening to what ministers say. Since then, the promise has been that taxes will fall – only for them to rise. We have seen the unnecessary National Insurance increase and more people brought into higher tax brackets through fiscal drag. Corporation Tax is set to increase, and even students have been hit by an indirect tax as the cost of their student loans have risen.While sound money is necessary as the public finances recover from the pandemic, it would be wrong to think that targeted tax cuts cannot play a key role in helping this.The economic consensus appears to be that there is not scope to cut taxes. An indication of the future direction of travel was reflected last week in a pessimistic assessment of the fiscal challenges facing the UK. The OBR’s annual risk assessment pointed to additional tightening “of £37 billion a year in today’s terms at the beginning of each decade” to stabilise the public finances over the next 50 years.It sounds very bleak, but it should be taken for what it is – an interesting and independent point of view. Not a cast iron fact. I believe it is far too pessimistic. Indeed, the margin of error on even one-year ahead official budget forecasts is huge. Thus, projections about what might happen by the middle of this century should not tie policy hands now – especially in the midst of a cost-of-living crisis. But it goes to the heart of the current debate.
The Treasury orthodoxy is that the UK is a slow growth economy. Thus, more of the budget deficit is structural, explained by underlying forces, as opposed to cyclical, linked to where we are in the economic cycle.If you believe that more of the deficit is structural then that points to squeezing government spending and higher taxes. This tax aspect has been much in evidence in policy thinking in recent years – it is like being in a hole and digging deeper.Such thinking is misplaced and needs to be turned on its head. The question should be: how can we grow the economy at a stronger pace? Indeed, that is why taxes have to be seen in the context of an overall growth agenda.When it comes to a focus on tax cuts now, the issues include whether they would be inflationary, what impact would they have on interest rates, and whether they are affordable. The key is to have timely and targeted tax cuts.If the economy was facing an inflation problem triggered by economic over-heating because of surging domestic demand then it might be legitimate to say that taxes could not be cut now and that fiscal policy should be tight. But that is not what is happening.In fact, the economy faces twin challenges of higher inflation and weakening demand, with a slump in consumer confidence. Meanwhile the causes of higher inflation have been supply-side pressures and lax monetary policy. Thus, there is a need for a tighter monetary policy to curb inflation and a looser fiscal policy, centred on tax cuts, to offset weaker domestic demand.Thus, tax cuts need not be inflationary, particularly if targeted. Furthermore, given the economic challenges we face, monetary and fiscal policy are not opposite ends of the same seesaw. If the right tax cuts are made, inflation will not rise. In fact, the Bank of England has suggested that the existing cost of living support package might boost inflation by just 0.1%.Possible tax cuts can be broken into three distinct categories.First, there is the necessary help for those on low incomes hit hard by higher energy bills. I pushed Boris Johnson for timely, targeted and temporary help to those most in need and this was forthcoming. More such help may be required this autumn, as the energy price cap rises significantly further.Second, is possible help to mitigate the impact of higher fuel and energy prices. There are a range of options here.Earlier this year, the Government announced a 5p cut in Fuel Duty per litre. According to a road fuel review released last week by the Competition and Markets Authority (CMA) there was “no evidence that retailers in aggregate have profited from failing to pass on the 5p fuel duty cut.” Given that, one can be confident that other such tax cuts, whether in fuel duty or in VAT on fuel, would also be passed on fully.
This is important, as such tax cuts would clearly not be inflationary, and would help reduce costs in the supply-chain. They would also be helpful to small firms and to people in rural areas. According to the CMA, over the last year households have paid on average more than £500 to run a medium sized petrol car, with VAT now accounting for close to thirty pence of the price of a litre. Other taxes on fuel, such as fuel duty, could also be cut if needed.Then there are possible tax cuts to help the squeezed middle, such as reducing income tax or raising allowances to pull people out of fiscal drag whereby they have crept into higher tax brackets. These make sense, and would help demand, but their timing needs alignment with other factors.Tax cuts that help the supply-side of the economy should also be welcome in inflationary times. This might include suspending the planned increase in corporation tax next spring as the CBI has called for, along with more attractive investment allowances. But there is no point in cutting such corporation tax to very low levels, as that would contravene OECD minimum corporation tax agreements – meaning firms might not gain from our lower tax while we would lose revenues.But just as growth is key for judging the overall tax environment, when it comes to firms, the key again is not tax itself – as important as this is – but rather to have a policy focused on ensuring that UK firms are competitive. In addition, when it comes to small firms – the bedrock of the economy – it is noteworthy that the Federation of Small Businesses has called for tax simplification, noting that in a digital world the average firm spends £4,300 and 52 hours per year on tax compliance.At the same time, higher inflation means that some additional funds will need to be allocated in the autumn Budget to spending areas to maintain expenditure in real terms on areas such as health and education. The case for a low tax economy is strong. It goes hand in hand with world class and well funded public services, but there needs to be public sector reform.The fiscal space that the OBR acknowledged existed after this year’s Spring Statement has been boosted by the impact of higher inflation in boosting tax revenues.There is fiscal space to cut taxes, but not all of them at the same time. Realism is needed. But after the tax increases of recent years, a supply-side, pro-growth agenda has to include tax cuts.