Britain's Supply-Side Turn

Truss's new government aims for growth through tax cuts and deregulation

Greetings, The War on Prices subscribers,

Last week, I outlined the history of what being a “supply-sider” on economic policy actually meant.

The principles, as first set out by Nobel prize winner Robert Mundell, and then Reagan’s economists, were essentially that:

1. monetary policy should be responsible for dealing with inflation;

2. tax policy should be set to ensure good incentives for work, investment, and economic output (rather than prioritize demand management or debt management); and

3. regulatory policy should be set to avoid needlessly harming the supply of goods and services.

In today’s mini-not-a-budget-budget in the UK, Liz Truss and her new Chancellor Kwasi Kwarteng (pictured above) pivoted UK policy to such a supply-side approach. They reiterated the Bank of England’s independence and responsibility for controlling inflation. They put a 2.5 percent target for economic growth as their major government priority. And they set out tax and regulatory policy plans to try to boost the growth rate towards that end.

Let’s set aside for a second the debate over the actual efficacy of their measures in achieving that target. What’s clear is that they believe that a combination of marginal tax rate cuts and supply-side liberalizations of important markets will raise GDP by increasing hours worked, improving productivity, attracting more talented people and businesses to the UK, and raising net investment. Indeed, taken together they offered the biggest net tax cut since 1972 (somewhere likely just over 1.5% of GDP in static terms) and set the scene for deregulation in the provision of all of energy, infrastructure, childcare, and housing.

This, to be clear, was exactly what the new Prime Minister said she was going to do, so I’m somewhat surprised by the scale of the market gyrations it caused (more on that later). But the tone of the statement suggested that if Truss could ride out the inevitable political blowback, this could be a really serious turning point for the UK, with policy set to move in a more small state, free-market direction again.

A list of just some of the measures proposed (remember, some require legislation) is actually quite astounding as a one-time package:

On tax…

• the recent 1.25 percent employer and employee national insurance tax rises have been reversed;

• the basic rate of income tax would be cut from 20 percent to 19 percent;

• the highest 45 percent marginal income tax rate would be abolished entirely, making 40 percent the top official marginal rate band;

• the threshold above which stamp duty (the property transactions tax) is due will rise to £250,000, and £425,000 for first-time buyers;

• the planned increase in the corporate profits tax has been abandoned (so maintaining it at 19 percent);

• full and immediate expensing in the corporate tax code for the first £1 million invested in plant and machinery would be made permanent;

• new investment zones would be introduced, in which there would be a 100 percent first year enhanced capital allowance relief for plant and machinery and building and structures relief of 20 percent per year.

On regulation…

There was far less direct detail today, but it seems clear that:

• new investment zones would encompass streamlining existing planning applications (and these are potentially big zones, if the councils and authorities in discussions are any guide - the Greater London Authority, for example);

• environmental reviews would be shortened and reformed;

• childcare deregulation proposals (probably on staffing and occupational licensing) are forthcoming;

• new planning reforms for housing are forthcoming;

• the onshore wind generator ban will be lifted;

• the fracking moratorium has been lifted;

• the cap on bankers’ bonuses will be abandoned;

• agricultural regulation will be reformed;

• the sugar tax and lots of other anti-obesity regulations will be abandoned;

• the arduous tax rules on contractors known as IR35 will be scrapped;

• all future tax policy will be reviewed through this prism of simplification;

• there will be an expansion of the number of welfare claimants who must submit to more intensive work coaching with the aim of increasing their hours.

Micro Reactions

Despite what some are claiming, this is not a “populist” or Keynesian package, but clearly a supply-side one.

Ending the cap on bankers’ bonuses, cutting the top rate of income tax, green-lighting (in principle) fracking, and even keeping corporation tax low are not “popular” measures with voters. Nor would the package above be what you’d do if you were trying to generate consumer spending according to some rank Keynesian logic (let’s leave aside that aggregate demand is determined by the Bank of England anyway).

That means we should debate the policies on their intended supply-side merits. From that perspective, each of the major tax cuts have rationale in microeconomic terms.

With the income tax and national insurance measures, there are marginal rate cuts on earned income across most earners. These will increase the returns to work and human capital accumulation. At the very top end, the abolition of the 45 percent tax band will improve the incentive for top talent to locate in the UK and, on the margin, improve the likelihood for transformative entrepreneurial innovation too.

Stamp duty is a dreadful tax that gums up property transactions and so leaves workers and families in houses inappropriate for them (it is one of the most inefficient ways to raise revenue), so cutting it such that around a third of homes on the market are exempt entirely will raise GDP by improving allocative efficiency. Keeping corporation tax low and steady will make some corporations more likely to headquarter in the UK, and combined with more generous investment allowances, lower the effective marginal tax rate on the new business investment that the UK so desperately needs.

Sure, this tax package doesn’t solve everything. It didn’t address the insidious “inflation tax” currently caused by the fiscal drag associated with freezing of income tax thresholds. Harmful anomalies remain in the UK’s income tax code too (such as the 60 percent effective marginal tax rate as the personal allowance is removed above £100k). And the overall burden of taxation on the UK economy will still be historically very, very high.

But it set a marker for the sort of tax reforms we are likely to see under a longer-term Truss administration: focusing on reducing marginal rates and cutting the taxes deemed most harmful to economic growth. And with monetary policy tightening, these sorts of supply-side tax cuts can hopefully help ease the output path from a high-inflation environment to a low-inflation environment.

The devil is in the detail on the supply-side regulatory efforts in other essential markets, but on the face of it they could be even more important. Truss will face big battles with vested interests and parts of her party on each, but reforms of land-use and permitting are absolutely essential to win if a much higher period of growth is to materialize.

Most analysts understand that Britain’s land-use planning is a noose around the economy’s neck, killing agglomeration benefits, preventing the fluidity of workers and businesses, and causing a host of downstream economic problems. But permitting of infrastructure and energy supply projects are a big issue too, as is the high-cost and scant availability of flexible childcare. Alleviate these constraints, and I think the UK economy could grow relatively quickly en route to a higher level of GDP.

Macro Reactions

That a bunch of individual tax policies might be good economics may not necessarily mean doing them all at once is a good idea. It’s fair to say, I think, that financial markets were surprised at the scale of the additional borrowing.

Now, logically, the actions of Truss and Kwarteng are what prioritizing growth looks like. For years, the UK approach has been essentially to set out first what public spending it wanted to do (falling under Chancellor Osborne, rising under Chancellor Sunak) and then mapping out a path for taxes to finance those ambitions. Growth was seen as a different, secondary objective of policy. That produced a historically high tax burden, alongside pathetically weak growth.

Putting growth first instead means setting tax rates to increase output and investment, then reviewing the level of spending you can afford sustainably subject to what revenues you raise.

Given Truss had articulated her tax cut plans, what I had expected to happen was something like this: with the UK a small open economy, significant additional borrowing would lead to rising gilt yields and higher economy-wide interest rates in the first event. The pound would then strengthen as additional capital was drawn into the country to finance the deficit, so pushing interest rates down again.

But we didn’t see the appreciating pound (at least after the first few minutes of the speech). And that crystallized a nagging fear of mine that significant, permanent tax cuts would, in isolation, be seen as fiscally irresponsible alongside the massive energy intervention. Working out the precise economics of why we saw the combination of the falling pound and rising gilts is difficult to parse from financial market data, but can only really logically be explained as a fear in markets that the UK might engage in “fiscal dominance,” with the Bank of England eventually being too permissive on inflation, and keeping rates too low, to help out a government with high and rising debt.

I think that this is very much an overreaction and misguided, if indeed the rationale for market moves. The Treasury documents insisted that the government would ensure the debt-to-GDP ratio falls in the medium term, even if that means a tighter grip on public spending. Truss herself has been hawkish on public expenditure through her career. Her and Chancellor Kwarteng have in the past denounced structural borrowing, backed a Swiss debt brake type rule, and talked about how spending cut-led deficit reduction is less damaging for output than tax-rise led consolidation packages. On the campaign trail, Truss said she would get public spending growth below the growth rate of the economy. She thinks the Bank of England haven’t been hawkish enough on inflation, remember. And in this statement, she is effectively tolerating significant real-terms spending cuts to many departments in light of higher-than-expected inflation already, seeing off significant pressure to increase outlays on public services.

Yet where economic policy is concerned, it’s always better to show rather than tell. That’s why just a couple of weeks ago I insisted that we should see some down payment from the government on cutting spending to show they wouldn’t tolerate ever-rising debt, perhaps alongside the announcement of new fiscal rules. It’s likewise extremely important that the Chancellor and Bank Governor Andrew Bailey do not deviate from the message that the latter will do whatever it takes to get on top of inflation.

Overall

In sum, I thought the actual measures contained within this statement were welcome. Given the Bank of England is trying to squeeze demand to get inflation out of the economy, real supply-side efforts can help avoid squeezing real output too hard. But it’s a) important to deliver on the actual deregulatory aims, b) to reiterate a longer-term commitment to spending control, and c) not to oversell the narrow growth impact of the tax cuts alone - which, though I don’t think will be as “costly” as the Treasury static scores suggest, are still mainly about reversing recent tax rises.

As I’ve mentioned previously, a lot of the commentary around this statement, comparing it to the Barber Boom budget, has been utterly absurd. In the early 1970s, the money supply was also growing at over 20 percent per year, at the same time as tax cuts were being delivered. It’s little surprise inflation surged. This time is in theory more akin to the Reaganite policy mix of tighter money alongside better supply-side incentives. But the government might have made its job a bit easier explaining this credibly if they’d recognized that Britain is not the U.S. and so offered much more clarity on how debt would be managed in the longer-term.