Our fortnightly series continues.
Why going for growth has failed
Reducing public expenditure to make room for tax cuts — or cutting taxes to force reductions in spending — is not easy.
But, in theory, there is another, less painful way to make more room for tax cuts. Instead of trying to reduce the size of government in absolute terms, the alternative is to reduce spending as a percentage of GDP. This doesn’t require direct cuts to the public sector. Indeed, government expenditure can continue to grow as long as the rate of growth is slower than that of the overall economy.
Sharing the proceeds of growth
The going for growth strategy may be closely associated with Liz Truss, but it didn’t start with her. Indeed, it was a favourite message of the Cameron government, even in the hardest of the austerity years. The grim determination of “we’re all in this together” was intercut with the sunny optimism of “sharing the proceeds of growth” — that is, between tax cuts and extra funding for public services.
However, though there were some tax cuts — such as the reductions in the rate of corporate tax — the overall tax burden during the 2010s did not vary much and ended up more-or-less where it started. Also while there were some increases to public spending — notably to the NHS — the deep cuts made to most departmental budgets were only partially reversed.
So while sharing the proceeds of growth sounds good, the truth is that there was never that much growth to share.
Then, with Covid, things went from disappointing to disastrous. Despite all those years of austerity, the tax burden in 2021-22 rose to 34.2 per cent of GDP. Furthermore, according to OBR forecasts, they’re set to rise still further to 37.7 per cent by 2027-28.
Not only would this be a post-war high for the United Kingdom, it would wipe out all the gains of the Thatcher (and Major) years. For tax-cutting Conservatives it is too much to bear. After half-a-century of struggle to roll back the state, and return money to the pockets of hard-working Britons, we’re basically back to where we started.
The party’s dismay rose to the surface in last year’s leadership election — which was won by Liz Truss who stood on a platform of immediate tax cuts. She moved quickly to make good on her promises. Her Government’s Growth Plan 2022 — unofficially known as the “mini-budget” — was announced to the House of Commons on 23rd September.
As the name suggest, it was all about boosting GDP. Indeed, there was an explicit recognition (on page 15 of the plan) that the growth rates achieved under the Cameron and May government were distinctly sub-par: i.e. an annual average of “just two per cent” compared to the 2.5 per cent in the twenty years before the Global Financial Crisis.
So how did Truss and her Chancellor, Kwasi Kwarteng, propose to do better? The Growth Plan outlined a number of deregulatory measures, but unlike the Osborne era (which also featured a Plan for Growth in 2011), there would be no waiting for growth to pick up before cutting taxes. Rather, the cuts would come first — in the hope of supercharging the growth process.
We never found how much this would have added to the national debt. For a start, there was no OBR projection of the impact on our public finances. But more to this point, the market reaction was so cataclysmic that it rapidly took down the Chancellor, the Prime Minister and almost every tax cut in the Growth Plan.
The rest of the 2020s
The collapse of Trussonomics so rapid and complete that the Conservative Party has never fully reckoned with it. In picking over the wreckage, the debate has fixated on details like whose idea it was to abolish the 45p additional rate of income tax or whether the Prime Minister was adequately warned about the vulnerabilities of UK pension fund investments.
However, these specifics matter a great deal less than the bigger picture, which is that the UK is an especially weak position to ‘fund’ tax cuts (or spending increases) through borrowing.
Since the millennium our public debt to GDP ratio has more than tripled from 28 per cent in 2000 to 101 per cent in 2022. There are only three previous occasions when debt has risen so vertiginously: the Napoleonic Wars, the First World War and the Second World War. By peacetime standards, we’ve placed ourselves in an unprecedented state of indebtedness.
It’s not just the amount that we owe that contributes to the fragility of our situation, but also the way that UK debt is structured. For instance, compared to other countries an unusually high proportion is owed to foreign lenders. The interest rate payable on UK bonds has increased sharply and is now in the upper range for G7 countries. Worst of all, our liabilities include by far the highest proportion of index linked bonds of any G7 nation — meaning that our debt servicing costs are correspondingly more exposed to the re-emergence of inflation.
It is therefore no wonder that the markets reacted so badly to a tax giveaway that was both unfunded and larger than expected. We may not like the idea of foreign interests having the power to bring down a British government, but given just how much money we’ve borrowed from them — and the terms on which we’ve borrowed it — we only have ourselves to blame.
Looking ahead, our competitors have plans to cut their own post-pandemic debt burdens. For instance, after the latitude of the recent years, the EU is re-introducing tough fiscal rules. If nothing else, the rise and fall of Truss has taught us a valuable lesson, which is that the United Kingdom is in no position to stand out from the crowd. Her successor, Rishi Sunak, has no plans to do so and his government is committed to a set of fiscal targets to ensure that public debt will fall by 2027-28.
The 2030s and beyond
Then there’s the longer-term fiscal outlook. The 50 year forecasts in the Office for Budget Responsibility’s Fiscal Risks and Sustainability report show that over the next 25 years, keeping a lid on debt levels depends on maintaining fiscal discipline and avoiding further shocks. Afterwards, beyond the 2050 horizon, the challenge becomes even tougher. Given the interaction of demographic factors with the welfare state, our long-term public finances are on an unsustainable path.
This isn’t just true of Britain alone of course. The ageing of populations means that debt levels are set to explode across the West unless long-term structural adjustments are made. Over the next two to three decades nations will have to fundamentally reshape their finances of find themselves increasingly exposed to market panics.
In this context, the idea that a country can lift itself out of trouble by unleashing a debt-fuelled sugar rush of tax cuts is going to seem naive at best and reckless at worst.
But should we be afraid of 50 year forecasts? The ageing of the population may be predictable, but the impact of technological change is not. Breakthroughs like artificial intelligence could catapult western economies out of their current stagnation. A return to healthy growth, compounded over the coming decades, would mean that we’d have the resources to deal with demographic change and climate change and all the other changes and still have plenty leftover for tax cuts.
It’s an optimistic scenario and government policy should do everything it can to support the innovators and entrepreneurs. However, the truth is that going for growth does not guarantee a small state. We don’t need forecasts to convince us, we just need to look at the historical record.
Without exception, industrialised economies are several times the size they were a hundred years ago. Mathematically, that creates a lot of room for the state to shrink as a percentage of GDP, but historically that is not what happened. That’s because the growth of the state — and especially the welfare state — is capable of keeping up with, or exceeding, that of the economy.
It’s a pattern sometimes referred to as Wagner’s law — named after the German economist, Adolph Wagner (1835-1917). The precise correspondence between economic growth and state expansion is contested — it’s closer in some countries than others. But while it’s not perfectly predictable like a law of physics, there’s no denying the general relationship.
Of course, over the short-term, any increase in economic growth makes it easier to find the money for tax cuts. But over the longer-term, political effects work in the opposite direction. Indeed, it could be argued that faster economic growth makes it easier to increase taxes, not cut them.
For a start, tax rises don’t hurt so much when they’re coming from expanding wage packets bolstered by plentiful consumer credit. Furthermore, a growing gap between what JK Galbraith called “private affluence and public squalor”, increases electoral support for tax-and-spend policies.
Growth also makes it easier for governments to borrow — because lenders are reassured that revenues will be sufficient to service an increasing level of debt.
Therefore even if a country goes for growth and succeeds, that’s no guarantee that the state will shrink, or that the tax burden will fall.
None of this means that conservatives shouldn’t seek to promote economic growth. We would, quite literally, be living in the Stone Age without it. We owe almost everything that makes-up the modern world to the expansion of the economy. But there’s one thing that growth hasn’t done — and that is to roll back the frontiers of the state.
For that we will require a very different strategy.