Beware of the tax-cutters

Slashing the tax take now will lead to increased public spending for years to come

Tim Congdon

This article is taken from the August/September 2022 issue of The Critic. To get the full magazine why not subscribe? Right now we’re offering five issues for just £10.

Tax-cutting Toryism has been on the rampage. Most of the early Conservative leadership candidates have committed to tax cuts, and in some cases these were to be early and big. The claim was that these would reflect the candidate’s support for Thatcherism, with its signature themes of a small state and low public spending.

The truth is not so simple. There is a problem here of what economists sometimes call “time-inconsistency”, although that phrase has a rather different connotation in the highbrow journals.

Public expenditure is of two kinds: payments of interest on the national debt and outlays on all other items. The earlier and bigger are tax cuts, the sooner and more rapidly does the budget deficit increase. Further, the larger is the budget deficit, the faster are the increases in the national debt and debt interest.

This implies a paradoxical and unwelcome result. Tax cuts now enlarge the size of the state in the years to come and increase the future burden of public spending. Margaret Thatcher was well aware of the vicious dynamics of indebtedness. That is why her government put strong public finances before low taxation.

Thatcher certainly approved the budget

In the celebrated 1981 budget her first chancellor of the exchequer, Sir Geoffrey Howe, increased taxes in a recession. He wanted to ensure the budget deficit would be on a downward path over the medium term. Thatcher certainly approved the budget. Indeed, 10 Downing Street — not No. 11 or the Treasury — is sometimes said to have been the source of the ideas behind it.

The argument may seem a little theoretical. After all, does it not imply the pessimistic message that — for any given pair of ratios of public expenditure and budget deficit to gross domestic product — tax cuts are always counter-productive in the long run? That is in fact the message, unless tax cuts result in a stronger rate of output growth and hence a larger tax base.

The supply-side school of the 1980s pressed this proposition in their advocacy of President Reagan’s tax cuts. But under Reagan the United States Federal debt exploded relative to GDP. By contrast, during the 1979-97 Conservative governments a key achievement was that a fall in the ratio of public debt to GDP was accompanied by a drop in taxes.

The nub of the matter is that a society known for the strength of its public finances enjoys the confidence of financial markets. Investors are therefore prepared to buy its government’s debt at a low rate of interest, and that limits the debt interest bill.

On the other hand, irresponsible tax cuts forfeit investors’ respect and their willingness to acquire new debt issues. As Rishi Sunak was warned by Treasury civil servants ahead of his final bust-up with Boris Johnson, the UK has already run into serious trouble on this score.

Yields on government bonds have risen sharply, with a nasty effect on debt interest. To quote from the documents that accompanied the 2022 budget:

Debt interest spending is forecast to reach £83 billion next year [2022-3] — the highest nominal spending ever and the highest relative to GDP in over two decades. This is nearly four times the amount spent on debt interest last year [£23.6 billion in 2020/21] and exceeds the budgets for day-to-day departmental spending on schools, the Home Office and the Ministry of Justice combined.

These words must have struck home and perhaps explain the caution of Sunak’s recent statements on tax and spending. An important consideration here is that past episodes of heavy deficits — and then of surges in public indebtedness — have often coincided with recessions, as recessions hit tax revenues and boost benefit expenditure.

On past form, the Bank of England will be able to bring inflation down from an almost double-digit annual rate only by increasing interest rates, curbing demand and causing a recession. If so, the present moment is not the right time to be rushing into tax cuts.

No one can applaud its financial record

Boris Johnson’s premiership was important because it did deliver Brexit, but no one can applaud its financial record. The jump in the number of civil servants and the undue expansion of government can be blamed on Covid-19 to a large extent, but there have been too many reports of a tendency to over-promise, regardless of cost.

If there is any -ism that will be attached to the Johnson period, it is not Thatcherism, but cakeism. Boris, often said to be rather improvident in his personal financial affairs, was inclined, as prime minister, to spend beyond the limit and to want his cake of lower taxes too.

The indulgence in tax-cut rhetoric may have been intended to establish the leadership contenders’ Thatcherite image with the Conservative party membership. There can be little doubt that for most of them Thatcher was an iconic figure who rescued Britain from its 1970s reputation as “the sick man of Europe”. But unearned tax cuts — tax cuts that cannot be justified by previous reductions in the ratio of public expenditure to GDP — should instead be viewed as Johnsonian cakeism at its worst.

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