Paying for the pandemic
This is no time to start putting up taxes
As the nights have been drawing in, so the fiscal picture has started to darken. Treasury officials, recently joined by the Chancellor, have been warning us about impending tax rises. You will all know the backdrop. Government borrowing has soared to levels unknown in peacetime. Accordingly, the stock of government debt has risen alarmingly and is still rising. Supposedly, somehow or other, we need to take action to “pay for the virus”. But do we really need to raise taxes?
The economic damage from the virus – or rather from the lockdown imposed to contain it – consists of the fall in output, consumption and investment. In that sense, we have already largely “paid for it”.
Once the economy has fully recovered, we will still have suffered that loss, which is largely irrecoverable.
And we will be left with the financial consequences, including the Government’s huge deficit.
In this context, you can see why higher taxes strike some people as inevitable.
Yet higher taxes would damage economic performance.
They blunt incentives and cause distortions, thereby reducing productive potential.
Moreover, they reduce aggregate demand as they withdraw purchasing power from the economy. They may even reduce tax revenue.
An alternative would be to reduce the deficit by cutting government spending instead. Here also, though, there are potential problems.
It all depends on what sort of spending you cut. Cutting productive investment damages growth potential. Meanwhile, all government spending – even the wasteful sort – contributes to aggregate demand.
One exception is spending on foreign aid. Not only does this not deliver any boost to UK productive potential but it doesn’t boost UK demand either since the money is spent abroad.
In our current straitened circumstances, if any part of government expenditure deserves to be trimmed, it is surely this.
And then there is the Brexit factor. Even Brexiteers like myself have recognised that there is a potential downside to the economy in the immediate aftermath of Brexit as businesses and individuals are confronted by radical change and feel uncertain about the future. The way to counter this is to bolster their confidence and to take measures that highlight the future potential of this economy and the people making their living within it.
This is not what higher personal and corporate taxes would do. They would risk an exodus of both talented people and successful businesses.
‘Higher taxes can blunt incentives and cause distortions, reducing productive potential’
Indeed, there is a case for cutting taxes on both individuals and businesses in order to ensure that we get the best Brexit lift-off.
Of course, the deficit needs to come down and likewise the ratio of government debt to GDP. The issue is largely about timing.
As Britain fought for its life during the Second World War, can you imagine being obsessed by the level of government debt?
In practice, we let the debt ratio rise to a peak of about 250pc of GDP (compared to today’s 100pc) and only sought to bring it down once the war was won. Moreover, we sought to do this gradually. This should be the approach now.
Mind you, wherever we can, we should try to finesse the difficulties of our current financial position. At the moment, the huge level of government debt is causing few problems because interest rates are low and the Bank of England is hoovering up the new debt issued. But things will not stay this way forever.
The Treasury’s nightmare is that interest rates will rise at a time when the government debt ratio is still enormous. Then we could face a serious financial crisis.
Peter Oppenheimer, the Oxford economist, has suggested a way of avoiding this danger.
If the real threat in the current situation concerns refinancing risk, then why not postpone the refinancing, or even eradicate it altogether?
The latter would be achieved by the issue of perpetual bonds, that is to say bonds that have no redemption date.
This may sound like pie in the sky but in fact it is very far from it. In the past, we have issued many perpetual bonds, starting in the 18th century.
Indeed, there were some perpetuals – also known as “irredeemables” – still in issue until recently.
The most famous of them was War Loan, issued in 1917 to help finance government spending in the First World War.
The Government had no obligation to redeem War Loan at any particular date. In the end, it was redeemed (at the original issue price) in 2015.
A less extreme version of this would be to rely more on long-term debt, where the redemption date is far into the future.
The longest gilt-edged security is currently about 50 years. We could easily issue more of such gilts – or even some with a maturity date further off. However, even this would carry costs.
At the moment, the interest rate on these ultra-long gilts is about 0.8pc per annum, which is extremely low by all historical standards.
But the Government can borrow on short maturities at negative interest rates and, on the stock that is held by the Bank of England – of whatever maturity – the cost to the Exchequer is just 0.1pc per annum.
So it is a matter of balancing the security of knowing that the interest rate will not go up for a very long time – or even, with perpetuals, ever – against paying a higher rate of interest now. That is a difficult judgment call.
Which brings us back to broad strategy. Assuming that the Government doesn’t splurge more money on “deserving causes”, the deficit is going to fall sharply anyway as special support measures are wound down and tax revenues rise in line with the recovering economy.
It is not yet clear that we need to bring it down faster. If we do, we should trim inessential current spending and dump duff investment projects.
Meanwhile, bringing down the debt to GDP ratio can wait.
An immediate hike in taxes is unnecessary. And it would be deeply damaging.
Now is not the time for Rishi Sunak, the Chancellor, and Prime Minister Boris Johnson to consider tax increases