We were told that Friday’s “fiscal event” was not going to be a Budget. It wasn’t even going to be a mini-Budget. In the end, there was certainly nothing mini about it – except the absence of a forecast of the UK economy and the public finances. It was big, bold and brave. But will it work?
The scale of the overall package was breathtaking. It amounted to a loosening of fiscal policy of almost 2pc of GDP, on top of the hugely expensive energy price cap. This is the biggest fiscal relaxation since 1972. That is an ominous comparison because that year the then chancellor of the exchequer, Tony Barber, unleashed a dash for growth which is now known as “the Barber Boom”. For a time, growth was indeed extremely strong but things didn’t end well. Inflation soared and in 1976 Britain had to go to the IMF to secure a loan.
Much of the content of this fiscal package we already knew about, including the reversal of the recent increase in National Insurance contributions and the cancellation of the planned increase in corporation tax. Similarly, the reduction in stamp duty had been trailed in the press.
By contrast, the abolition of the 45p higher rate tax band came completely out of the blue. The 45p rate is a relic of the 50p rate deliberately introduced by Gordon Brown in 2009 as an electoral bear trap for the Conservatives. George Osborne announced a cut to 45p in 2012 but neither he, nor subsequent chancellors, dared go further. Has the new chancellor walked straight into the bear trap?
Abolishing this higher rate was the right thing to do but its political wisdom is questionable, particularly since it came on the same day as the chancellor announced the end of the cap on bankers’ bonuses.
Admittedly, this cap was a daft measure introduced by the EU in the wake of the financial crisis and it served no useful purpose. But that’s not how things will be seen down the Dog and Duck. At least the 1p cut in the basic rate of income tax (which costs much more in lost revenue than the abolition of the 45p rate), can be seen as a benefit to the ordinary person.
As well as improving post-tax incomes, the ambition of the package was to boost the supply-side of the economy and the chancellor announced several measures to this effect, including a strengthening of the sanctions regime for Universal Credit and a tightening of the laws governing strike action.
The most significant of the supply-side measures was the announcement of 40 enterprise zones within which the tax privileges are going to be substantial. I suspect that these zones are going to be successful in improving the performance in those particular economic areas. The problem with such policies, however, is that there is a tendency to divert economic activity from other places, with the result that there is not much impact on overall economic performance.
Actually, I am a bit more optimistic than this because the wide disparities in economic performance across our economy depress the overall economy. If we can successfully redistribute economic activity towards less well-functioning areas then that will relieve the pressure of demand on those parts of the country which are congested and under strong inflationary pressure.
The chancellor and prime minister will no doubt argue that the cuts in tax rates will also potentially have a favourable effect on economic growth. They may have a bit of a point with the abolition of the higher tax rate. This may encourage more high earners to stay, or locate themselves, here.
But the 1p cut in the basic rate of tax will have next to no effect in encouraging people to work harder or more people to join the workforce. This is not to say that a substantial cut in the tax taken from ordinary workers is not a worthy ambition. But to make a serious difference the cuts need to be on an altogether larger scale and they need to reflect genuine reductions in the tax burden, not a shifting about from A to B.
Getting the growth rate sustainably higher will require a big increase in business investment. Rescinding the planned increase in corporation tax will help but on its own it will surely not cut much ice. The Government will need to develop measures that give a greater incentive for business investment.
The fiscal package came only a day after the Bank of England raised interest rates by 0.5pc. The chancellor has upbraided the Governor of the Bank of England for the Bank’s failure to get on top of inflation. From what he has said, he seems to believe that the Bank could potentially reduce inflation without reducing aggregate demand.
Simultaneously, he appears to believe that he can boost aggregate demand through his fiscal policy without making the task facing the Bank of England any more difficult. In practice, monetary and fiscal policy work through the same channels, affecting aggregate demand and thereby inflation.
After last week it seems clear that we are set for much higher interest rates. I suspect that the Bank rate will have to rise to somewhere between 4 and 5pc. Already, the yields on government bonds have jumped. Britain’s yawning external deficit will probably widen. All of this carries the risk of the pound weakening a good deal further.
You cannot criticise the new team for a lack of radicalism. After just a couple of weeks they have announced measures that make this seem like a completely new government. Their ambition of raising the growth rate to 2.5pc is a worthy one. But the measures that they have so far announced on the supply-side merely scratch the surface, while the boost to aggregate demand is bigger than almost anyone envisaged. Financial markets will be watching intensely. It is going to be a very bumpy ride.
Kwarteng may have walked straight into Gordon Brown’s bear trap
Abolishing the 45p higher rate was the right thing to do – but its political wisdom is questionable