The September 2022 Trussonomic “mini-Budget” by UK Chancellor of the Exchequer (finance minister) Kwasi Kwarteng claimed that cutting personal and corporate taxes will drive economic growth and pay for themselves. Some have suggested that this is the same as the “Reagan” tax cuts of the early 1980’s that cut taxes and increased the US fiscal deficit.
Underlying both sets of tax cuts is a price of economic theory, the Laffer Curve, that was dreamed up (although its author claims it has deeper roots) on a restaurant napkin in 1974 during a lunch between economist Arthur Laffer, US politicians Dick Cheney and Donald Rumsfeld and a journalist. The famous napkin has been memorialised as a museum item in Washington DC! The Laffer Curve theory asserts that growth rises when taxes, especially personal taxes, are cut. It has been extended over the years by some US based think tanks to suggest that personal tax rates need to be set below an optimum level to drive growth.
Easy to comprehend, and as we saw in Kwarteng’s 2022 statement easy to claim as a growth generating measure how does it perform in the real world? According to a detailed study performed by US economist Austan Goolsbee in 2009 such policy delivers poor and unsubstantiated results (Goolsbee 2009). Coincidently, these results should be no surprise as they reflect similar historical experience. For example, when the Roman Colony of Britannia decided to stop paying its taxes to Rome at the start of the 5th Century in response to the Roman Emperor moving the army (that the taxes were paying for) away from Britannia to deal with trouble in Gaul, the dramatic tax cut (to zero) led to demonetarisation and economic stagnation.
Notwithstanding, dropping a personal tax rate from, say 98% to 40% will likely impact economic growth, provided this is only occurring in one nation. Big changes in single nations do make a difference as President Hollande of France found when he increased the top rate of tax in France and key entrepreneurs left in response. Large changes in personal tax rates and large differences in tax rates between countries do make a difference, but smaller changes such as abolishing a 45% top rate tax band to leave income taxed at 40% is unlikely to change entrepreneurial behaviour.
Instead, such tax cuts are likely to increase the public sector deficit whilst having no material impact on economic growth. Could this be one reason financial markets reacted so strongly to the Kwarteng September 2022 tax cutting announcement?
Handbag or Tinkerbell?
“So come with me where dreams are born and time is never planned. Just think of happy things and your heart will fly on wings forever in never never land.” E M Barrie Peter Pan
The United Kingdom has another new government ready to drive the Brexit Dividend. The late Mrs Thatcher’s “Handbag Politics” of demanding concessions and giving nothing in return has returned as the new Truss administration looks to deliver Brexit benefits and resolve tensions in the “Northern Ireland Protocol”. In the 1980’s the “handbag” achieved the famous UK budget rebate. Will a robust approach work now or has Tinkerbell’s “all you need is faith, trust and little bit of pixie dust” taken over from reason?
Today, there are three very distinct differences to the early 1980’s and one huge question. To the differences, first, this time there are reduced incentives for the EU to give concessions in order to sweeten future working relationships, as the UK has already left the EU. Second the EU faces huge challenges on its Eastern Border with the Ukraine war and the subsequent ceasing of Russian gas shipments. Third, the international context is becoming ever more complex in a post pandemic world with fracture supply chains, conflict in Europe, tensions in East Asia and rising inflation.
This time the Brexit Dividend is to delivered by driving growth though slashing tax and regulation, “downsizing” the state and implementing open Free Trade. Economic Shock Therapy to shake up complacency and drive an economic renaissance. What then are the chances that such an approach could work?
Historical parallels such as the 35%+ GDP fall in Russia after the fall of the Soviet Union where it with its trading network, slashed tax and removed regulation in one go show such changes can be challenging. These can and often are mitigated by significant international support such as the EU support given to Poland and other Eastern Bloc countries after 1991. Even so, structural adjustment of an economy via shock therapy can still be painful. In these cases, GDP still fell by over 25%.
On taxation, except when taxes are extortionately high, there is scant evidence that cutting personal and corporate tax stimulates innovation and business investment. Far more important to generating economic growth are public private partnerships (especially those supporting innovative small firms) often delivered by either defence contracting (USA) or by direct intervention (i.e. China) to share new product development costs to launch new technologies. These require access to reasonably priced risk finance to fund business investment. This is still a significant UK problem, notwithstanding the support provided by the British Business Bank.
Notwithstanding, a blast of open competition can be helpful in sectors that have been protected from international markets and so failed to innovate. There is a strong argument for sunset industries to be required to compete globally, but only if capital and talent that would have been allocated to these is switched into new growing sunrise sectors. Undertaking this switch is always challenging, often as with the early days in Silicon Valley, requiring state support to provide sufficient certainty for private investment to be forthcoming.
The significant drop in Sterling that seems to be under way will squeeze real wages and consumption as inflation rises in response to currency depreciation. A key challenge is to use this adjustment to redirect resources from consumption into business investment that builds the global champions of tomorrow.
Rather than relying on tinkerbell our work suggests that such a change needs careful nurturing within a complex model of cumulative causation, where economic, social and innovation factors come together to drive a virtuous cycle of growth.
Alternatively, can UK become an “ultra-low cost” deregulated assembly location next to Western Europe? A UK “China” at the gates of Europe? For this to happen will need Chinese levels of capital investment and Far East levels of real wages. Firms that compete in mature price sensitive markets either raise productivity to reduce unit costs or they don’t survive.
“Screwdriver Shop” focused on mature industries that serves a European market at a lower price than from East Asia, or “Workshop of the World” creating, making and selling the high margin products of tomorrow in well-resourced sunrise industries? The choice is ours, but it feels like maybe this a bit more complex than wielding a handbag to obtain what we want.
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