Lessons from Britain’s policy crisis

The now-ousted Chancellor’s proposal was to reduce the top tax bracket from 45% to 40% and reduce overall taxation from 20% to 19%

The United Kingdom has had four Prime Ministers in the last six years. Their most recent Chancellor of the Exchequer (i.e., the finance minister) was sacked in a record 38 days after presenting his mini-budget. This was even though the budget had plenty of tax cuts and fiscal packages to help families meet rising energy costs. The financial markets, instead of cheering the tax cuts, brought the financial system dangerously close to the brink of collapse. The government had to intervene in the bond market to prevent a bottomless fall. This is not exactly expected in a country that houses the world’s biggest global financial centre.

There are more such anomalies. The Conservative Party has been running the government for the past 12 years. Yet, contrary to the image of Conservatives as standing for tax cuts, the taxes have actually risen. Perhaps the present government, led by Prime Minister Liz Truss, was obliged to swing toward far-right policies of drastic tax cuts to undo the tarnished image of Conservatives as high-tax supporters. Or perhaps the PM believed that tax cuts would boost economic growth. Or maybe she believed that cutting taxes would increase tax revenue, a view attributed to supply-side economists.

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The now-ousted Chancellor’s proposal was to reduce the top tax bracket from 45 per cent to 40 per cent and reduce overall taxation from 20 per cent to 19 per cent. Even corporate tax rates were to be kept at 19 per cent and not moved to 25 per cent. The problem was that the bulk of the gains from the cuts, nearly half of it, was going to the top 5 per cent income earners. This looks bad when inequality is increasing, and it is not even clear that the tax rebate would lead to fresh investment. Indeed, the corporations are likely to just show higher profits, and not fresh investments into new projects. Higher profits could increase their share price but not the GDP.

Despite the supply-side mantra of tax cuts leading to an increase in tax collection, we have seen in many countries, including in India, that at moderate levels, reduction in tax rates do not increase tax revenues. It might make sense when you have absurdly high marginal tax rates like 95 per cent, which India had in the 1970s. But when marginal rates are around 25 per cent, the phenomenon of the Laffer Curve (named after Arthur Laffer who propounded the theory of tax cuts leading to an increase in tax revenue) is unlikely to work.

The proposed tax cuts by the Truss government were thus the most drastic ones in the last 50 years. Hence, to make up for the anticipated shortfall in revenues, the Chancellor also announced a fresh borrowing program of nearly 60 billion Pounds. These tax cuts and increases in fiscal borrowing got a thumbs down from financial investors. You can’t fool financial investors, especially if the budget is not credible.

There was a bond sell-off, and the value of bonds went down sharply. This means that those funds which have bond portfolios on their balance sheets lost value. This affected large pension funds, which tend to hedge their interest rate risks using derivatives. With the sharp fall in portfolio values, they had to inject liquidity to refill (called “margin calls”). The refill money was to be collected by selling liquid assets, i.e., bonds, aggravating the bond sell-off. This was spinning out of control, and the UK government had to step in to avert the bottomless fall. This intervention was to the tune of 62 billion Pounds, unheard of in a developed country.

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The financial system had come close to collapse. Even the International Monetary Fund, which is usually diplomatic, was blunt in its criticism of the budget proposals. At a time when inflation is at a historic high of 10 per cent, it was fiscally reckless to announce drastic tax cuts and fiscal expansion. This policy would only aggravate inflation. Hence, the government has had to make a U-turn, and postpone, if not cancel, the tax cuts. Jeremy Hunt, the new Chancellor, has his work cut out. The Prime Minister may lose her job if the instability continues. The lessons to learn from the UK crisis are the following.

At a time when income and wealth inequality has risen sharply, you do not resort to trickle-down economics. That is, you do not award large tax cuts to the income-earners at the top end, hoping that their increased spending will eventually trickle down as new jobs and incomes for those at the lower end of income-earners. When there is so much uncertainty, not just because of the unending war in Ukraine, it seems unlikely that the rich would redirect their tax rebates into fresh investment.

Secondly, when inflation is raging, you do not pursue further fiscal expansion. This is something that India’s Finance Minister also has indicated as a possible guidance about her forthcoming Union Budget in February.

Thirdly, at a time when oil prices are very high, instead of a cut in corporate taxes as announced in the mini-budget, it would be better to slap windfall gains tax, which has been tried in the UK itself. India, too, is experimenting with windfall gains tax on oil companies.

Fourth, the fresh investments will have to come from public investment in infrastructure, which can crowd in, rather than crowd out, private investment. Hence, fiscal resources should be saved for these fresh investments, rather than frittered away in tax cuts.

Fifth, much attention has to be paid to the stability of the financial system.

The UK experience showed that derivative exposure of pension funds led to big calls for making up the shortfall, causing the bonds to fall further, triggering a vicious cycle. This means that the financial system’s resilience must be greater. If there is a huge stock market sell-off in India, will there be a domino destructive effect via balance sheets, and margin calls? Are banks too leveraged or overexposed or have concentration risks? These are some of the lessons to be learnt. The silver lining in the UK is that the government in its U-turns has been seen as responsive and a quick learner!

(The writer is a noted economist) (Syndicate: The Billion Press)