Recent weeks have seen the UK press full of fevered speculation about potential large-scale tax rises, of as much as £40-50 billion. Press speculation of this sort is a standard pre-budget ritual. But the latest round of it has sparked a particularly sharp political response with some Conservative MPs threatening to vote against the budget if tax rises are included, which would be an extraordinary move. In our view, these MPs are right and Treasury officials – who seem to be behind these press briefings – are, yet again, wrong.
Let us consider the economics of this issue first. The case for tax rises is that the recession created by the coronavirus crisis is set to open up a big ‘hole’ in the government’s finances, perhaps even threatening financial stability. In an article clearly briefed by Treasury sources, Fraser Nelson informs us that the Treasury has run a stress test which allegedly showed that the government ‘is already right on the financial edge’ and that ‘it would not take much for the country to topple over’.
The current budget situation is certainly very bad. This year, the UK budget deficit is likely to come in at around 15% of GDP, a level never before seen in peacetime. The UK debt/GDP ratio has risen above 100% and will rise still further by year-end.
But this year’s deficit largely reflects an extraordinary level of spending associated with the coronavirus crisis. In the second quarter of the year, government revenues dropped but largely in line with the fall in GDP. Meanwhile, spending soared by almost 14% of GDP. About half of this extra spending was subsidies – mostly the furlough scheme for employees – with a quarter being higher government consumption (including on health-related items like PPE) and a further quarter bailouts for local authorities (Chart 1).
This additional spending will drop away as the coronavirus crisis eases and the economy reopens. There are already clear signs of this. The use of the furlough scheme has already contracted considerably (with its total cost starting to level off) and extraordinary costs in areas like health have also declined. July’s public finance data showed public borrowing at only around half the peak level of April and borrowing will shrink further in the rest of Q3 following the large-scale easing of restrictions.
But what about the supposed risks to financial stability, that could tip the UK ‘over the edge’? The first point we would make in response to this is that if such risks really existed, we would have seen evidence of them already – most obviously in a sharply rising cost of government borrowing. But the opposite has happened, with UK government gilt yields dropping during this year from around 0.7% for 10-year money at the start of the year to around 0.2% now (Chart 2). The bulk of the heavy borrowing the government needs to do this year has already been done, but there are no signs of negative spillovers to the bond market.
With the government borrowing mostly at long maturities, the additional interest costs created by this year’s borrowing will be very low. Borrowing £300 billion at 0.3% means an additional interest bill of just £900 million per year which is around 0.04% of GDP. The overall interest cost on the government’s accumulated stock of debt has fallen to around 2.5% which means that financing a debt stock of 100% of GDP costs 2.5% of GDP. This is actually quite modest by historical standards – it was higher in 2007.
There could still be a long-term hit to the public finances if economic activity is permanently lower due to the effects of the coronavirus crisis. Some forecasts suggest GDP in the long-term might be perhaps 1.5% lower. If we take 2025 as the long-term and assume government revenues move broadly in line with GDP, this implies revenues lower by £40billion or so by then. This kind of reckoning is the source of some of headline tax rise figures that have been bandied about.
But forecasts of the long-term impact are finger-in the-air exercises at this point – we really have little idea what the long-run effect on GDP will be especially as the recovery from the crisis has only just got going. There could be permanent effects on some tax bases (e.g. business rates, stamp duty etc.) if there are long-term structural changes in the economy – but we just don’t know.
Sharp rises in taxation now on the basis of an unknown long-term economic effect make no sense, especially because, as we have already noted, there are no pressures from the bond market to do so. It makes much more sense to wait and see.
Moreover, tax hikes now risk being totally self-defeating by strangling the incomplete – and fragile – rebound in the economy (remember, there are sectors of the economy that are still closed like much of the arts and entertainment world). The government needs to be pressing for the strongest recovery possible at this point, as this is the real route to restoring the health of the public finances.
In addition, the level of taxation is already clearly above its long-term average, with tax revenue as a share of GDP (ex-petroleum revenue tax) only having been higher in a few years of the last forty years – and never for a sustained period (Chart 3). Raising the level of taxation sharply from the current level would be a dubious proposition even in good times as it would risk damaging long-term growth. In the current environment it verges on lunacy.
Bearing all this in mind, what are we to make of the Treasury’s attempt to bring in big tax rises? We can dispense quickly with the notion that their reasoning is based on sound economics. The ‘stress test’ results they claim inform their thinking look very flaky. Our own workings suggest that far from the UK being ‘on the edge’, it would take a dramatic deterioration of key variables like growth and interest rates to put the UK at risk of some kind of financial crisis. Borrowing costs are near zero and the debt/GDP ratio has been far higher in the past and is likely to start declining again next year as the economy rebounds from this year’s large contraction.
There are two other possibilities. First, the Treasury may be using the fiscal situation to push forward some of its pet projects including an assault on pension tax relief, hoping to smuggle a few such items into the budget by exaggerating the fiscal risks. Second, the Treasury may be hoping that shroud-waving about a financial crisis will somehow affect government decision making on another topic which it obsesses about – Brexit.
We hope the Chancellor and the government will have the good sense to ignore the Treasury’s warnings. Indeed, the example of the Treasury’s behaviour on Brexit should strengthen their resolve to do so. Dubious, agenda-driven modelling featuring unrealistic assumptions is not the basis for sound policy making and we hope the current incumbent of No.10 is not as easily persuaded by such modelling as some of his predecessors.