What are the Economic Challenges Facing the New Prime Minister?

Given the announcements the various candidates have made, it looks very much like we will have a ‘tax-cutting’ Prime Minister come September.  But how does that mesh with the OBR’s ‘Fiscal risks and sustainability’ report that came out last week?

In their ‘fiscal risks and sustainability’ report, the OBR sought to give a “comprehensive understanding of the interplay between the near-term threats to the fiscal outlook and the long-term health of the public finances”.  They looked at the potential effects on the public finances of rising geopolitical tensions and higher energy prices as well as the longer-term fiscal pressures coming from an aging population and the loss of existing motoring taxes as we move to a net zero economy.  Their long-term projection showed that the need to increase spending on health care, pensions and social care as the population aged, together with the loss of motoring taxes, meant that debt would rise to over 100 per cent of GDP by 2052-53 and reach 267 per cent of GDP in 50 years.  If the government supported the economy in response to future negative shocks – as we would hope and expect – then, clearly, the debt to GDP ratio would rise by more.  As an example, the OBR found that if geopolitical tensions led to an increase in defence spending, together with a major trade war, the debt to GDP ratio could rise above 400 per cent in 50 years time.

Of course, that is an unlikely, though still plausible, set of shocks.  But, even their benchmark projection implied that, if the government wanted to bring back the debt to GDP ratio to the 75 per cent at which is stabilised in the March 2020 budget, fiscal policy would have to be tightened by 1.5 per cent of GDP or £37 billion in today’s money at the beginning of each decade over the next 50 years.  Against this backdrop, a new Prime Minister would only be able to cut taxes in a way that was sustainable if they were also to cut back heavily on spending.

And will tax cuts not lead to even higher inflation at a time when UK households are already facing a fall in their standard of living?

 The exact effect of tax cuts on the economy depends on which taxes are cut.  For example, cuts in employers’ National Insurance Contributions encourages employment whereas cuts in VAT directly encourage spending.  That said, cuts in any taxes are likely to increase demand.  And an increase in demand – for a given level of supply – will lead to an increase in inflation.  An argument could be made that cuts in some taxes (for example, NICs or Corporation tax) might lead to an increase in supply.  However, even if that is the case, it is extremely unlikely that the increase in supply would match the increase in demand and, anyway, would not be as immediate.  A cut in VAT will – assuming it is passed through – lead to an immediate fall in prices, offsetting some of the inflationary effect.  But, if the cut is permanent, this offset will only affect the annual inflation rate for one year.  And, if the cut is temporary, then pass through is likely to be lower as firms will try and avoid changing their price twice.  Either way, the VAT cut only affects measured inflation:  it does nothing to affect the underlying inflationary pressure in the economy.

Against this, income tax cuts will raise households’ disposable income, which will offset, possibly fully, the effect of higher inflation on their real disposable incomes.  The problem here is that the poorest households in society – who are facing the largest squeeze on their cost of living – typically pay little if any income tax – as they are either unemployed or earn less than the income tax threshold – and so would not be helped by such a tax cut.  As my NIESR colleagues have argued extensively, a rise in universal credit is a much better way of supporting such households.

One final point on inflation.  Although cuts in taxes will lead to an increase in demand and, other things equal, inflation, the Monetary Policy Committee would, of course, want to offset this by tightening monetary policy.  As a first approximation, you would think that the offset would be exact and so the tax cuts would have no effect on inflation.  But, it may be that tax cuts increase demand more rapidly than monetary policy would reduce it, in which case the tax cuts would still lead to a temporary rise in inflation.

On the other hand, tax cuts may help stop, or at least lessen the impact of, a recession later this year.  How do you see the evolution of UK GDP over the coming months?

To be honest, I’m quite worried about the evolution of the UK economy over the coming months.  I’m expecting GDP to fall in the third and fourth quarters of this year and possibly the first quarter of next year as well.  I’m hoping that these falls will be relatively small.  But even then, this is likely to lead to a rise in unemployment at a time, as you said earlier, where households are already facing a fall in their standard of living.  As I argued earlier, tax cuts would lead to an increase in demand and so reduce the fall in output, and possibly keep the economy out of recession.

But, that still leaves households facing high inflation and a fall in their standard of living.  And, as I said earlier, this is being felt – and will continue to be felt – most strongly by the poorest households in our society.  Rather than blanket tax cuts, I would like to see more targeted support for these households.

Finally, what do you see as the most important challenge facing the incoming Prime Minister, whoever she or he may be?

As we’ve discussed, the incoming Prime Minister will face a number of severe challenges.  Inflation is likely to remain high throughout the rest of this year and next.  The UK economy is likely to enter a recession in the third quarter of this year, if it is not already in one.  The ongoing war in Ukraine and the issues around higher energy and food prices associated with it, not to mention the associated security and geopolitical issues.  Rewriting the Northern Ireland Protocol and all the inevitable fallout from that both within Northern Ireland and in terms of our relationship with our EU colleagues.  And there are the longer-term challenges of doing something about the UK’s woeful productivity performance and steering the economy to net zero.  It’s very hard to pick out the most important of these many challenges! If I had to choose one, though, I would go back to the issue of the ‘Cost of Living’ crisis.  The recent support announced by the Chancellor will have helped many low-income households.  But with energy bills due to go up again in October – and the current support not being particularly well targeted – there is both the need and the scope to do more.  And I think that – rather than cutting taxes – should be the first thing the new Prime Minister gets to grips with.