David Gauke is a former Justice Secretary, and was an independent candidate in South-West Hertfordshire at the 2019 general election.
Economics is at the heart of this leadership election and will be at the heart of the wider political debate for the foreseeable future. Low growth, soaring inflation (especially energy prices), high taxes and public services under financial pressure all contribute to a focus on economic vision and competence.
Part of Liz Truss’s appeal to the party membership is that she is the economic change candidate. She has a retail offer – tax cuts – and a willingness to challenge powerful institutions such as the Treasury and the Bank of England. She believes that her policies will increase economic growth by strengthening the supply side of the economy. The big question is whether Trussonomics will work.
The issue that has attracted the most attention is her policy on tax cuts. Her argument is that by not going ahead with the increase in National Insurance Contributions and Corporation Tax she will assist with the cost of living challenge and attract more investment to the UK. She maintains that these tax cuts will encourage economic growth and, therefore, help the public finances and strengthen the supply side of the economy, thus potentially being deflationary. Rishi Sunak’s counter-argument is that loosening fiscal policy will be inflationary at a time when there is no spare capacity in the economy.
On Corporation Tax, Truss has a point that international investors have a choice as to where they invest and reducing their rate of return on investment (which is what increasing Corporation Tax does) is bound to have a negative behavioural impact. It is not the most important factor influencing investment decisions (our falling rates were insufficient to counteract the uncertainty created by the result of the 2016 referendum), but it is one that the Government can easily control. An efficient tax system would seek to rely less heavily on it as a source of revenue.
I spent six years in the Treasury bringing down the Corporation Tax rate and was one of the few who objected to its increase when announced in March 2021. Having said that, Corporation Tax cuts do not pay for themselves and the benefits will only be seen over a long time period. They are certainly not disinflationary in the short term.
The more fundamental argument on tax policy is whether her approach is reckless. The inflationary argument can be overstated. When Sunak announced in May measures to help with the cost of living with a net giveaway of £10 billion, the Treasury thought that this might add 0.1-0.2 per cent to inflation all other things being equal.
A £30 billion giveaway would presumably add 0.3 to 0.6 per cent to inflation. In practice, looser fiscal policy will result in tighter monetary policy, so the net effect will not be higher inflation but higher interest rates. Assuming that market confidence is maintained (to which I will return), the additional increase in interest rates is unlikely to be very substantial.
The real problem is not inflation, but that Truss’s plans look set to widen the structural deficit by reducing the tax base. It is not plausible to think that this is going to be removed by lower spending (she plans to spend considerably more on defence and the pressures on health spending are immense), with demography increasingly working against us.
Truss has a point that the UK is moving faster than other countries to restore the public finances post-Covid, but it is not clear when or how she would ever take action. For a party that once prided itself on fiscal responsibility, it is an approach that looks risky.
In addition to having a go at Treasury fiscal orthodoxy, Truss has also been critical of the Bank of England and talked of setting “a clear direction of travel” on monetary policy. The Bank of England has been slow in tightening monetary policy and cannot expect to be exempt from criticism, even though it has been operating in challenging circumstances.
What is not yet clear is whether Truss’s intention is simply to tell the Monetary Policy Committee to pull its socks up and be more vigilant in future (with an implicit rebuke to the Chancellor of the Exchequer for the past two years) or if Ministers are set to interfere more. There is a lower profile debate ongoing in respect of financial services regulation, in which Ministers may end up with greater powers contained in the Financial Services and Markets Bill to rewrite regulations not to their liking.
If Truss’s plan is for a greater role for Ministers – and a reduction in independence for bodies that were previously operationally autonomous – problems lie ahead. Some will argue that such moves would increase accountability, but they would also mean a greater concentration of power and greater politicisation of matters that have, until now, been in the hands of experts insulated from public opinion. Many Conservatives may welcome this; the markets may not. Weakening independent institutions also comes with substantial risks.
An issue that has not featured heavily in the leadership debate so far is Europe. Both candidates are (now) Brexiteers, both deny that Brexit has contributed to delays at Dover (which is clearly untrue), both support the Northern Ireland Protocol Bill. Sunak, however, gives the impression of being a relatively pragmatic. Notwithstanding his vote for Leave in 2016, party members are detecting this attribute and do not like it.
Truss, by contrast, has the zeal of the convert and owes the European Research Group and Lord Frost for getting her to the final round. Rumours are swirling in Whitehall that a Ministerial position at the Foreign Office – possibly as Foreign Secretary – awaits Frost, and it is difficult to see how Truss can retreat from the hard line position she has taken in negotiations with the EU hitherto. It is also hard to see that the EU would be keen to reset its relationship with the UK in the event that Truss won, especially if they have to deal with Frost.
This issue has attracted little attention during the contest but the risk of a further deterioration in UK/EU relations is underestimated. A failure by the UK to comply with our obligations under the Trade and Cooperation Agreement may result in severe retaliation from the EU which could involve the loss of tariff-free, quota-free access to EU markets.
Finally, Trussonomics apparently involves lots of deregulation. But promises of deregulation in the abstract without the details count for little. Vague pledges won’t unleash growth.
So where might Trussonomics leave us? The best case scenario is that her fiscal policies give us a short-term boost, an increase in the structural deficit and marginally higher interest rates; the institutional changes amount to very little; and she finds a way to resolve the Northern Ireland Protocol challenges that leaves the TCA intact, even if that means disappointing some of her backers.
The worst case is that the UK appears fiscally irresponsible; our independent institutions are undermined; and we have a trade war with our most important export market. This combination of factors causes a perfect storm in which we lose market credibility, sterling takes a further hit, interest rates rise sharply and business investment and consumer confidence collapse.
My guess is that she is too smart to allow the worst case scenario to happen. To do that, however, she is going to have to move swiftly from focusing on winning the confidence of Conservative MPs and party members to winning the confidence of the markets. That may prove to be a much tougher test.