What would a pro-growth leadership pitch on tax look like?
What you cut, not just how much, matters
The key debate in this Conservative leadership election will be on the economy. All candidates are committed to some form of low-tax agenda, but there’s a clear divide between fiscal conservatives, who refuse to borrow more to cut taxes, and supply siders, who support deficit-financed tax cuts on the grounds they will deliver growth down the line. (In practice, this divide is between Rishi Sunak and, to varying extents, every other candidate.)
The fiscal conservatives have a fair few points in their favour.
We are coming out of a pandemic where the debt as a share of GDP has grown massively.
The Government has already adopted two fiscal rules (below) designed to allow greater flexibility on spending. If the plan is to relax either rule (e.g. extending the time period on rule one, then a fiscal conservative can ask the question: Why do you want to adopt Corbyn’s borrowing policies?)
Over any three-year period, underlying public sector net debt, excluding the impact of the Bank of England, must, as a percentage of GDP, be falling.
In normal times the state should only borrow to invest in our future growth and prosperity. (In practice this means borrowing is only allowed for capital projects such as infrastructure.)
Economic credibility in terms of reducing borrowing and keeping interest rates low has been vital to the party’s case to the electorate.
Inflation is high and does not appear to be purely transitory. Any additional borrowing will force the Bank of England to increase interest rates, which will dampen the growth benefits of tax cuts and hurt important parts of the Conservative’s electoral coalition.
High energy costs are likely to mean additional short-term targeted support for the most vulnerable is needed. This will reduce the UK’s fiscal headroom.
Public services are falling apart making it nigh-impossible for politicians to advocate spending cuts. If I leave my office, I see 100 metre long queues outside the passport office. Our court system is beset by delays and too few police mean that clearance rates for a range of crimes have fallen significantly. On top of that, demands for the NHS have increased significantly due to the pandemic creating a lengthy backlog.
On top of that, most public sector pay settlements are untenable in the face of 10% inflation. Pay restraint will be hard to maintain after more than a decade of real terms cuts.
On the other hand, the Supply Siders have a case too.
Growth in the UK has been too low for too long. In terms of GDP per head, we have fallen behind France and Germany, while the gap between the UK and the US has widened even further. Gaps can be closed too. New Zealand’s GDP per head was half of the UK’s in 2000 but in under two decades they caught up.
A failure to return to normal levels of productivity growth post-financial crisis has weakened the UK’s fiscal position significantly. If productivity growth returned after the great recession as the OBR predicted then the deficit would have been cleared in 2015.
Capital investment by UK businesses has been persistently low. This is not solely the result of taxation – energy costs matter significantly – but the UK normally (super-deduction notwithstanding) taxes capital investment at a higher rate than most of our trading partners. Once the super-deduction expires, the UK will rank 33rd out of 37 OECD nations in capital cost recovery according to the Tax Foundation. This, by the way, is more important when interest rates are high.
The existing fiscal rules allow borrowing for growth. This may be intended for capital projects (e.g. HS2), but it could easily apply to growth-enhancing policies which increase the capital stock. Expanding capital allowances (or even moving to full expensing) would increase long-run output significantly.
The Treasury does not typically produce dynamic models for tax changes. As a result, existing fiscal rules are, in practice, biassed against additional tax cuts.
The government’s interest bill may have risen, but inflation reduces the size of the national debt too. Fiscal drag also means that the last budget hiked taxes significantly and unless inflation subsides the next budget will do the same if thresholds are not revised.
The fiscal rules are relatively sensible, but fiscal rules have a tendency to influence policy in strange ways. Examples:
Policies with large upfront costs are discouraged, even if they cost less over the long term. This might explain why the NHS has extremely low levels of capital spend compared to almost every other healthcare system in the developed world.
There’s a tendency to shift costs off the books even if direct funding would be more efficient. This may explain, in part, why nuclear power plants have been so hard to build over the last decade. It might also explain why climate policies are often paid for through energy bills rather than general taxation.
Technical accounting changes can have major impacts on tax and spend decisions. For instance, the OBR changed the way it counted student loans in 2018, which substantially weakened the government’s fiscal position. (For what it is worth, I agree with the OBR’s analysis here.)
The OBR’s recent report suggesting long-term doom and gloom makes rather unrealistic assumptions about fuel duty. In effect, it assumes that as we switch to electric vehicles fuel duty revenues will decline and we won’t do anything on road taxation to compensate. In reality, some form of road pricing is likely to plug that £30bn a year gap.
The OBR suggests there is around £30bn per annum of fiscal headroom to meet the government’s fiscal rules over the next three years. This is hostage to fortune, but there is room to play with.
With that in mind, what would a credible, pro-growth leadership pitch on tax look like?
The next PM should use some of the ~£30bn fiscal headroom to cancel the planned rise in Corporation Tax. While Sunak was right to spot that there’s more to corporate tax than the headline rate (more on that below), it was a mistake to assume that the headline rate was basically irrelevant. The headline rate of corporation tax affects where businesses choose to invest. While it is hard to discern the impact based on the UK experience alone, robust cross-country studies consistently find strong impacts of corporate tax rates on investment. A consensus estimate from Michael Devereux at Oxford University’s Centre for Business Taxation finds a 1pp increase in the effective average tax rate leads to a 2.5% fall in foreign direct investment. It would mean that the rise from 19% to 25% will lead to a 15% drop in foreign investment. This, in turn, will have knock-on effects on productivity and wages.
It is worth noting that when the Chancellor announced his plan to raise corporation tax, Sunak noted that even with the rise to 25% "the UK will still have the lowest corporation tax rate in the G7" group of leading nations. This was premised on the belief that the US would follow suit and go from 20% to 28%. But, this didn’t end up happening.
The next PM should go further and commit to having the most competitive corporate tax system in the world. Importantly, this does not mean further cuts to the headline rate. To get the most growth-boosting bang for their tax-cutting buck, the next PM should prioritise increasing the generosity of capital allowances. The former Chancellor’s recent tax plan set out a range of potential reforms. Of which, the best option was moving to a system of full expensing, where business can write-off any capital expenses upfront in full. This would effectively convert the 130% super-deduction into a 100% deduction. The US adopted this system in 2017 and when top economists Jason Furman (Democrat) and Robert Barro (Republican) analysed the Tax Cuts and Jobs Act both agreed that full expensing was the most pro-growth measure. When Pedro Serôdio and I looked at the impact of full expensing on the UK economy using the best real-world evidence on the responsiveness of investment to capital allowances, we found it would boost UK GDP by 4.5% in the long-run.
Some might be sceptical after the apparent flop of the super-deduction, which failed to increase investment by anywhere near as much as forecast. But this shouldn’t have been a surprise. As I noted at the time, when there’s increased economic uncertainty and/or a recession, the link between capital allowances and investment breaks down. We should also distinguish between temporary and permanent measures. Investments are rarely one-and-done. So if follow-on investments do not attract the same capital allowances then businesses will be understandably cautious about investing.
My understanding is that before the Johnson Government collapsed, the Treasury were actively considering full expensing but were put-off by the high upfront sticker cost. While they were persuaded that the policy would increase investment and the cost would be reasonable in the long -run when the impact of stronger economic growth is taken into account, the measure was very hard to square with their fiscal rule which focused on balancing the budget over just three years. This seems to me a clear case where dogmatically sticking to fiscal rules is bad for the economy. As a compromise, the upfront costs of a move to full expensing could be treated in similar way to how infrastructure investment is treated under existing fiscal rules. Since this essentially is being done to allow capital investment –- just by the private sector, not the public sector
The next PM should fix business rates by transforming rates into a business land-tax. Not all pro-investment changes cost the exchequer. Few taxes inspire debates as intense as business rates, but the problem is that the debates focus on the wrong issues. Instead of focusing on levelling the playing field between bricks and mortar and online, we should be looking at how manufacturers who invest in new plants and machinery are penalised by higher rates bills. If rates were levied on underlying land values instead of property values, it would ensure that manufacturers struggling with high energy costs aren’t punished when they install a new energy efficient cooling system. As land values are highest in London and the South-East, the change would have the added benefit of rebalancing the UK’s economy.
The next PM should draw a line on fiscal drag and set a long-term ambition to return thresholds to 2010 levels (adjusted for wage growth). Despite relatively few headline tax rises over the last decade or so, the tax burden has grown substantially. Part of the reason why is that while wages have gone up a fair bit since then, thresholds have not kept pace. The recent decision to freeze thresholds despite high inflation was in effect a massive tax rise.
Over the past 30 years, the number of taxpayers paying the 40p rate of tax has tripled. In 1992, 1.6m paid the 40p rate of income tax. Today, three times as many (4.8m) pay it. And in 2026, the OBR forecast 6.8m will pay it if no action is taken. At a bare minimum, the thresholds for income tax and the Pensions Lifetime Allowance should be linked to wage growth from now onwards.
Fiscal conservatives, such as Rishi Sunak, are on stronger grounds to oppose deficit-financed tax cuts aimed at alleviating the cost of living. A VAT cut will not increase long-run growth, will push up borrowing, and in turn inflation. While VAT cuts stimulate demand, they have very little impact on the incentive to work or invest, which is what determines growth in the long term.
The political benefits will be short-lived as a result. I suspect this argument will be persuasive. Along the same lines, any cut to the basic rate of Income Tax or NI should be funded by spending cuts, not borrowing as there is no plausible argument that they will increase short- or medium-term growth.
As it stands, pledges to hike national insurance on one hand, while cutting income tax on the other seem unfocused and ad hoc. Instead, reductions in personal tax should be grounded in principle. I’m a big fan of Tom Clougherty at the CPS’s ‘work guarantee’. Essentially, it means that every worker should keep at least 51p in every extra £1 they earn. In other words, prioritise cutting the taxes that create unacceptably high marginal tax rates such as the 62p for people who earn between £100k to £125k and reducing the UC taper rate to 50p from 55p. If the aim is to increase economic growth, then tackling high marginal tax rates, wherever they may be, should be the priority.
Any agenda to reduce the overall tax burden significantly will need to be funded. Ultimately, there are effectively two ways to do this: cutting spending or promoting growth through supply-side reform (i.e. opening up markets to competition via deregulation). In practice, this means either tough choices and hard work.
Tough choices: Exposing closed markets to competition often involves taking on well-organised special interests. There’s a clear political cost here, alongside the gains from growth.
Hard work: In some cases, there’s no substitute for being detail focused. If you are clever you can create win-win schemes that split the proceeds of growth to overcome objections. I’m a big fan of ideas such as Street Votes which do this (see John Myers blog for more examples). Electricity market reform (for instance, making pricing more local to improve the economics of renewables) is one of the dullest topics known to mankind, but there are really substantial gains if we can get it right.
Economic growth must be seen as the priority. Fiscal discipline should only be justified in terms of improving living standards. The reason to keep borrowing down is to avoid inflationary pressures that force interest rates up and drive investment down. When fiscal rules unintentionally create incentives to shift costs off the books or discourage long-term investments, they should be changed.