Why tax increases are unlikely

In his Autumn statement, Rishi Sunak reiterated a timeworn Chancellor’s pledge to restore the public finances. Notably, he declared that the financial emergency had only just begun and that public borrowing and debt were clearly unsustainable. These statements, Treasury briefings and forecasts by the Office for Budgetary Responsibility have led analysts to start working out how much taxes need to increase in order to plug a gap of about £40 billion between the government’s revenues and its spending that is expected by 2025. Income tax, National Insurance, VAT, capital gains tax, inheritance tax – which will go up?

But there is a good case, now being argued by influential economists, that the gap may not matter much at all, and that in fact there is no ‘financial emergency’ and no need for tax increases any time soon.

Vast numbers – like the £394 billion the government is expected to borrow this year, nearly 19% of GDP – can appear frightening if taken out of context. But Mr Sunak himself said he expected COVID to account for just £55 billion of government spending in 2021-22 as compared with £280 billion this year - which might suggest that the financial crisis (if there is one) is already ending.

As for worries about the total of public debt, the UK’s ratio of public debt to GDP was about 80% before the pandemic. By 2025 it is forecast to reach 105% thanks to higher recent borrowing. Yet the ratio was actually higher than this in almost every year between 1920 and 1946. Britain did not go bust then.

Now consider the real issue about debt. As anyone who has ever been in trouble with debt will tell you, how much you owe is not the real issue. The crunch question is: can you afford to pay the interest?

In this case, there is even less of an emergency. Back in 1946, debt interest ate up 14% of UK government spending. Even in 1986, 8p of every taxpayers’ £1 was spent on paying interest on debt. Today it is just 2p in the £1. And thanks to low interest rates, this ratio will stay low for years to come. The government borrows by selling loans (gilts) with a 30-year life, on which it currently pays interest at under 1%. Can you really go bust in this scenario? Remember that in March, Sunak promised a binge of public infrastructure spending, most of which is projected by the Treasury to earn a return for the nation of far more than 1%. Should he stop spending that money because the debt-to-GDP ratio is rising towards 100%? That would make the nation worse off, not better off.

So you might ask why Mr Sunak is trying to frighten the horses. Clearly there is the usual red-versus blue politics. The Tories love to appear as the party of ‘sound money’ even though their record does not justify this. And the spending plans announced by the Conservative government last March were little different from Labour’s election manifesto plans. Sounding tough on debt is one of the few ways that Sunak can try to paint what has historically been seen as red water blue.

On the political theme, there is also the way the electoral cycle usually runs. We get austerity or tax increases in the early years of a Parliament, so there’s then scope for tax giveaways in the year before an election. If Sunak starts raising taxes next year, there might be scope for some small giveaways in 2024. But what would those tax rises do to the economy? Most analysts think next year is too soon to raise taxes as it could kill the expected recovery.

Then add in the estimate by political commentators that about a third of Tory MPs are vehemently opposed to tax increases, especially any that can be seen as attacks on business and entrepreneurs. This contingent includes many of the most ardent advocates of Brexit, the faction still driving the Tory bus.

Our conclusion is that Sunak will probably back away from any sizeable increase in taxes. If there is a strong economic recovery in 2021, helped along by the COVID vaccine, he will have a good case, because the government’s tax revenues always rise in line with economic activity.

Chancellors always play to the gallery, so we’d expect some tough rhetoric from Mr Sunak in next Spring’s Budget, with perhaps a few measures that raise taxes for the wealthy. But tens of billions in tax rises? We think not.