Macroeconomics: Liz Truss makes stunning tax-cut gamble as pound plunges

Truss, who has been prime minister since the beginning of September, delighted the right wing of the Conservative Party that installed her to replace Boris Johnson as leader with the £45 billion ($75 billion) tax cuts, primarily for top income earners, unveiled by her new Chancellor Kwasi Kwarteng on Friday (UK time).

What was billed as a “fiscal event” turned out to be a seismic rerouting of the UK’s economic approach, that included removing the 45 per cent tax rate for those on incomes of more than £150,000 ($250,000) and scrapped the cap on bankers’ bonuses that were imposed by the EU after the financial crisis.

 

The highest income tax rate will be 40 per cent and the planned lowering of the base rate of income tax from 20 per cent to 19 per cent will be brought forward by a year.

 

As flagged during Truss’ campaign to be leader, the UK will no longer lift the corporation tax rate from 19 per cent to 25 per cent and reverse a hike to the national insurance that the government, of which she was a cabinet member, approved to help pay for the pandemic costs.

 

And stamp duty will be cut for homes worth up to £250,000 ($420,000) and for £425,000 ($710,000) for first home buyers.

 

A planned shake up of the way alcohol is taxed will no longer take place, spelling good news for Australian red wine producers who would have stood to pay higher tariffs based on the alcoholic content of their drinks.

 

And tax-free shopping, stopped in 2021, will be reintroduced and made digital in a bid to encourage tourism and higher visitor spending.

 

This is on top of the energy relief that Truss already announced which Kwarteng on Friday confirmed could cost £10 billion ($17 billion) per month in the first six months.

 

He did not state the further estimated costs of the energy bills relief spending, nor the government’s massive tax cuts but defended the UK’s debt levels as the second-lowest debt- to-GDP ratio in the G7.

 

The UK’s gross debt as a percentage of GDP is currently 99.6 per cent down from the high of 103.8 per cent two years ago, at the height of the first pandemic lockdown.

People on benefits would have to increase their attempts to find a job or risk having their funds reduced, he warned. And in an attempt to bust the strikes that have been crippling Britain’s vital services in the past months, he flagged strike-busting laws that would force pay offers to go to members ballots and a minimum level of services mandated during industrial action.

 

He said the goal was to achieve 2.5 per cent economic growth

 

“We are at the beginning of a new era,” he told the House of Commons.

 

“The tax system is not simply about raising revenue for public services, vitally important though that is.

 

“We are securing our place in a fiercely competitive global economy, with lower rates of corporation tax and lower rates of personal tax,” he said.

 

“In due course, we will publish a medium-term fiscal plan setting out our responsible fiscal approach more fully, including how we plan to reduce debt as a percentage of GDP over the medium term,” he added.

 

The Labour opposition said the plan was more discredited trickle-down economics. Paul Johnson from the respected and independent Institute for Fiscal Studies said the government had announced the biggest package of tax cuts in 50 years but “without even a semblance of an effort to make the public finance numbers add up”.

 

He said the obvious risks of the government’s spending were fuelling inflation, which is currently 9.8 per cent, and the further deterioration in government finances.

 

“This is a huge economic experiment which carries with it lots of risks, as well as, we hope, the potential upside in terms of economic growth,” Johnson said.

 

Johnson said the spending spree was at odds with the Bank of England’s recent interest rate rises aimed at curbing inflation.

 

The markets reacted badly with the quickest spike in interest rates on government borrowing in three decades and the sterling fell against the greenback to below $US1.10, a 37-year low.

This article discusses the changes that Liz Truss is planning to introduce in the UK in 2021. The changes that Liz Truss wantsto introduce include tax cuts, “primarily for top income earners” and “scrapping the cap on bankers’ bonuses”. The tax cuts aim to “achieve 2.5 percent economic growth.” Liz Truss being the new prime minister brings change because she targets new macroeconomic objectives which include deferring from stable prices towards targeting economic growth through cutting a range of taxes and increasing government spending. Liz Truss aims to pursue economic growth through expansionary fiscal policy by cutting tax rates.

 

An unintended consequence of the Truss tax cuts could be increasing demand-pull inflation because an increase in aggregate demand, due to the tax cuts and additional borrowing, with limited parallel increase in aggregate supply could lead to demand pull inflation, as shown in Figure 3. The reduction in taxes may increase consumption and investment because they have more disposable income. The “tax-free shopping” will “encourage tourism and higher visitor spending” which will increase exports and hence increase economic growth. This increase in AD would cause inflation. The expectation of Truss’ expansionary fiscal policy in the short run is to increase economic growth, however, in the long run, the tax cuts and energy relief may not be sustainable.

With the changes that will be made to the tax system, it is expected that there will be an increase in aggregate demand (AD), as seen from Figure 3. AD shifts right because consumption in the economy increases, the cut in the highest income tax rate from 45% to 40% could be particularly significant, as these higher income consumers have more disposable income to spend. The inflation rate stands at 9.8% at PL₁, and consequently Lizz Truss changes could increase the inflation rate to PL₂. This is in direct contrast with the Central Bank’s stance because they have contractionary monetary policy meaning they are trying to decrease AD and target inflation whereas Liz Truss is trying to increase AD, the policies do not run-in congruence. This suggests that either the central bank or Truss must change their policy otherwise uncertainty will prevail, harming the UK economy. As Johnson said: “This is a huge economic experiment which carries with it lots of risks”. This uncertainty could lead to instability in the economy as the consumers have reduced confidence.

 

Increasing interest rates is a method used to control inflation because if the central bank charges higher prices to the commercial banks, then the commercial banks will charge higher prices to the borrowers and therefore curb the demand for goods and services. However, this will slow down economic growth because consumption would decrease which is a component of GDP. As a result of the demand-pull inflation, businesses respond by rising their prices. The result of expansionary fiscal policy is an increase in economic growth and that Liz Truss’ target may well be achieved however, it causes demand-pull inflation and the subsequent increase in prices across the economy adds to the problem of 9.8% inflation.

 

In addition, the cut in the taxes could result in a loss in government tax revenue which would later lead to increased amounts of government debt for the country because the government no longer has the budget from the tax revenue to fund the healthcare, infrastructure, salaries etc. for the country. The government will be spending more on the energy relief that they will impose. However, these still need to be funded somehow so these changes will put pressure on the government’s budget. The UK government might have to raise more debt to finance their expenditure. Some costs of this high national debt could include the debt servicing cost because it has an opportunity cost since it could be used in other sectors. However, the government argues that the “UK’s debt levels are the second-lowest debt-to-GDP ratio” in G7 countries. However, the table in the article shows their debt is still higher than Germany and the EU average.

 

The main argument for this expansionary fiscal policy is that it could increase economic activity. As seen from figure 3, with increased economic activity, even though tax rates are lower, there is a bigger tax space. Furthermore, it was stated that “borrowing billions to fund tax cuts for the rich and sacrificing company and healthcare tax revenues will spur Britain’s stagnant economy” suggesting that the tax cuts could be effective in increasing economic growth.

 

Overall, Truss is hoping that the changes forecasted will increase the UK’s economic growth to 2.5%. However, by cutting taxes and other expenses, there is concern for high levels of government debt, inflation, and uncertainty.