Boris Johnson is often dismissed as a know-nothing on economics, and Rishi Sunak prides himself on being rather good at it.
In his generally excellent recent Mais lecture, the Chancellor set out his vision for the UK economy. He aims for freeing up markets, improving regulation, and cutting taxes to incentivise investment, training and R&D. So far so good. But he argued that in the short term it was right to raise taxes to reduce debt. He said that Mrs Thatcher's government did this before cutting taxes later and cites this as a supportive precedent.
But on this he is totally wrong, as is obvious to his backbench MPs and to Boris. Raising taxes now is a horrendous mistake which, if not reversed, will damage growth and yes the public finances too, which depend hugely on growth.
The situation in 1981 when the Thatcher government raised taxes was entirely different. Inflation was running close to 20 percent and interest rates were around 15 percent. There was a lack of credibility over the ability of monetary policy to control inflation. There was a particular worry that the government would print money to avoid borrowing.
The tough budget of 1981 was necessary to create confidence in the control of inflation, so reducing inflation expectations and with them actual inflation; and so to allow interest rates to fall and permit recovery. As a result, recovery was strong in 1982 and inflation fell sharply.
Today interest rates are close to zero and there is no credibility problem for the Bank of England in controlling inflation; its problem until recently has mostly been too little inflation, while today's inflation comes from commodity supply bottlenecks due to the Covid cycle and the Ukraine war.
Now by raising rates moderately the Bank will have a strong dampening impact on inflation; if rates go even as high as 2 percent, the impact will be strongly deflationary. As for government borrowing, it can be done very cheaply with long rates at just over 1 percent, negative in real terms.
There is no pressure on the Government to cut its debt ratio; its solvency is assured, gilts are seen as a highly safe asset. Nor is there any need for borrowing to fall to buttress Bank anti-inflation credibility, as that is, as we have just seen, extremely strong.
There is, therefore, no parallel between the fiscal policy needs of 1981 and those of today. Then fiscal policy needed to tighten to underpin anti-inflation policy. Today fiscal policy needs to permit taxes to stay down to underpin growth, and monetary policy is easily capable of the necessary tightening to restrain inflation.
Indeed if fiscal policy promotes growth it will allow the Bank to raise interest rates further into more normal ranges, getting us well away from the dangerous zero interest rate region.
However, Mr. Sunak and his Treasury are arguing for tax rises to bring down debt, whereas Mrs Thatcher's supply-side approach would push for tax cuts to boost growth today, with strong growth the key to paying off debt in the long term.
If the Sunak/Treasury tax increases go ahead, including the massive rise in Corporation tax from 19 percent to 25 percent, we risk facing a catastrophic fall in growth and this in turn will create terrible public finances.
According to my research group's UK regional growth model (available at http://carbsecon.com/wp/E2020_14.pdf, to be published in Open Economies Review, which matches UK post-war data, growth responds sensitively to the business tax rate, and net UK tax revenue responds sensitively to growth.
The result is that, with the currently planned tax rises, UK growth over the coming decade would be cut by about 2 percent a year, with the North's cut by more than the South's.
The projections for public debt show the debt ratio worsening disastrously to 135 percent by 2035, presaging a doom loop whereby the Treasury, frustrated by the low tax receipts resulting from lower growth, wants to raise tax rates yet further, worsening debt even more and so on.
By contrast, with no tax rises,the debt ratio would come down to 50 percent within a decade with growth undamaged. Even better, tax cuts and spending rises financed by borrowing would boost growth and bring the debt ratio right down in the long run.
This all means that Boris Johnson has, in fact, got the correct approach to fiscal policy for our times.
He is rightly inclined to be in favour of more public spending, while not wishing to put taxes up because he knows it appals both his backbench MPs and Conservative voters.
This article first appeared in The Express
