David Gauke is a former Justice Secretary, and was an independent candidate in South-West Hertfordshire at the 2019 general election.
I have known a few fiscal events to go badly wrong very quickly. I have even had partial responsibility on a couple of occasions. Last Friday’s statement by Kwasi Kwarteng – which resulted in a sharp fall in the pound and increase in borrowing costs – is on a different scale.
Before setting out my own concerns, there are three points of mitigation in respect of the Prime Minister and Chancellor that should be acknowledged.
First, the test of a Budget is not its immediate popularity. The Government is right to argue that what really matters is the economic impact and progress often requires pursuing unpopular policies.
Second, we will see endless accusations that this is just the Tories supporting their rich mates; that it is all about paying back shadowy donors to Tufton Street think tanks; that this is an act of class war in which the wealthy exploit the poor. Plenty of people believe this but it is not true. I have no doubt at all that Liz Truss and Kwasi Kwarteng are sincere in their belief that the low tax policies they have set out will make the UK economy more competitive and productive, and that is the best way to raise living standards for the population as a whole and pay for better public services. It is not their motivation that is the issue, but their judgement.
Third, when it comes to two of the most controversial tax cuts – on corporation tax and the additional rate of income tax – there are respectable arguments to support the Government, at least in the abstract. Corporation tax is a tax on the return to investment and we want more investment. Most tax economists would argue that there are better ways to raise revenue.
As for the additional rate of income tax, we raise a lot of money from not many taxpayers (10 per cent of income tax receipts come from 0.1 per cent of the population) who tend to be internationally mobile. We should at least ensure that we are competitive in our rates for such people.
It is worth examining the three previous occasions in which Chancellors of the Exchequer have cut the top rate of income tax. Geoffrey Howe brought the rate down from 83 per cent (even 98 per cent on unearned income) to 60 per cent following the 1979 General Election. The previous rates were clearly absurd and uncompetitive and the Conservatives had been elected on the basis of restoring incentives in the tax system.
Nigel Lawson abolished all the rates above 40 per cent in 1988. This was the first Budget after Mrs Thatcher’s 1987 landslide general election victory and delivered at a time of a booming economy and, notwithstanding this policy and a reduction in the basic rate of income tax, there was still a Budget surplus.
The third occasion was the 2012 Budget – and one in which I was heavily involved – saw the 50 per cent rate (brought in at the very end of the Gordon Brown premiership) reduced to 45 per cent. The 50 per cent rate was seen as being internationally uncompetitive, and a study by HMRC had concluded that 50 per cent rate raised relatively little revenue compared to 45 per cent. Furthermore, this amount was a fifth of the sums raised from the wealthy from other measures announced in that Budget.
In each case, the reduction in the top rate was controversial but the circumstances were much better than is the case now. In 1979 and 1988, these were the first Budgets of a new Parliament. In 1979, we had a new Government; in 1988 we had a very strong economy with buoyant public finances. The circumstances in 2012 were more difficult, but the ground had been prepared and the change was in the context of a Budget that actually increased taxes on the richest. We even had the sign off of the Liberal Democrats. The public finances were nothing like as favourable as 1988, but at least the deficit was falling and projected to keep falling.
When setting out these comparisons, it is apparent how politically brave (by which I mean ‘foolhardy’) the Government is being. We are in the second half of the Parliament. The announcement came as a surprise; hardly anyone was calling for it. We are also about to face a winter when many will suffer the biggest squeeze in their living standards they will have ever experienced, notwithstanding the Government’s support packages, whilst public services are going to be under strain.
As for the public finances, this tax cut is not going to be paid for by other, less damaging taxes on the wealthy or as a consequence of years of financial prudence, but by an extraordinary splurge in borrowing. Put in this context, even those of us who think that we must be competitive in the ‘global race’ (to use a once fashionable term) look at this announcement with bewilderment, and wonder if the policies will give tax cuts a bad name.
In cutting the top rate of income tax, the Government has done itself serious political harm. In its fiscal approach as a whole, it has done the country serious economic harm. The risks of an adverse market reaction were obvious in advance of Kwarteng’s statement, and a wise Chancellor would have taken heed of it, especially after consulting with an experienced Treasury Permanent Secretary with a deep understanding of the financial markets. Unfortunately, the Permanent Secretary had been dismissed and Kwarteng ploughed on apparently oblivious to the risks.
The UK, already viewed sceptically by the financial markets, appeared to cross the line on Friday. The consequence is that those invested in Government bonds are poorer, taxpayers will pay more in debt interest and consumers will pay more for imports. As Larry Summers, former US Treasury Secretary, brutally put it, we are behaving like an emerging market turning ourselves into a submerging market.
What happens next? To a large extent, that will depend on the markets in the next few weeks. Matters may settle down with the pound and gilt yields stabilising. Or they may not. If the movements we saw on Friday continue into the next few days, the Bank of England will be placed into an appalling dilemma. Waiting until November for the next scheduled meeting of the Monetary Policy Committee may look complacent; calling an emergency meeting to hike up interest rates may look panicked.
An unscheduled meeting would also be a significant political moment. It would not be on a par with the IMF bail-out of 1976 or our departure from the ERM in 1992 but it would be a moment nonetheless, with potential repercussions for the future relationship between the Bank and the Government.
Such an eventuality may not come to pass; it is perfectly possible that the markets have adjusted as far as they need to go. But what is clear is that Truss and Kwarteng are willing to take the most enormous political and economic risks. Such an approach does not normally end well.