Chancellor must learn that low tax and growth go hand in hand
JEREMY HUNT’S Budget will damage the economy’s growth prospects by raising corporation tax to 25 per cent. He attempted to offset the effect by a new regime of investment allowances that replace the “superdeduction”. But the trouble with that is that productivity-raising innovation does not generally require physical investment on which allowances are based; its effect is seen eventually in intangible capital which attracts no allowances.
So the higher tax penalises productivity growth. The Chancellor’s words proclaiming his devotion to growth are therefore largely a waste of breath. Yes, I welcome the abolition of the pension cap and the raising of the pension limits on tax-free contributions, and the extra support of childcare; also the new investment zones. These are helpful support measures.
But economic theory emphasises the key role of tax on productivity growth, the heart of the growth engine. Decisions by businesses on innovation and investment and by multinationals on where to locate their foreign direct investment, in turn crucial to local technological progress, are motivated by expected profit after tax.
Hence, productivity growth, that results from this, is endogenous, i.e. affected by government policies, and not exogenous, falling or not like manna from heaven, which is how it is being treated conceptually by the Treasury and the Office for Budget Responsibility. For the latter two, business profits can be treated like a milch cow, without negative effects on productivity and growth.
It is not just economic theory that denies this. If one fits this theory of endogenous growth to UK data over the past three decades, the data support it, as my co-authors and I have demonstrated in recent published work. Furthermore, the analysis has been confirmed by announced business reactions, such as from Astra-zeneca, KPMG, and the CBI.
It is therefore sad and tragic that this Budget is set to destroy growth prospects by pushing ahead with the plan to raise corporation tax.
The reasoning behind the policy
The Chancellor’s words proclaiming his devotion to growth are largely a waste of breath
harks back to the long-running leadership debate between Rishi Sunak and Liz Truss. Since Mr Sunak became Prime Minister, he has reiterated his reasons for the policy. But as we will see, they are not persuasive, either then or today.
The Sunak/hunt regime is determined to stick with its restrictive fiscal policy, on the grounds that this is necessary to head off inflation and to remain solvent. The result is the economy running flat if not into overt recession in the short term, and with the corporation tax rise, weak growth in the longer term.
The grounds given are easily refuted. First, inflation. This is under the control of the Bank, which has raised interest rates sharply to bring inflation down to its 2 per cent target. Its success in this is now widely expected, with monetary tightening bringing money supply growth down close to zero.
Furthermore, the commodity price spikes that caused the sharp rise in costs are being reversed by worldwide monetary tightness, as well as the end of Covid and energy demand adjustment to the continuing Ukraine war.
Indeed, monetary tightness has now become excessive, as is shown by the latest banking crisis.
As for the contribution of fiscal policy restriction to inflation, this if anything will push it up through its direct effect on wage settlements. But in any case its effect is second order.
As for solvency, the UK’S market reputation remains strong and hardly altered during the Truss government. This is evident from the credit default swap market that insures sovereign default risk. The latest UK rate is under seven basis points (a rate of 0.07 per cent per annum), among the lowest in the world while Italy’s at the other end is over 90 basis points.
During the Truss period the UK rate peaked at 40 points compared with an Italian peak last July of nearly 200. The reason that UK long-term interest rates rose sharply during the Truss period was not solvency worries but concern that inflation would rise sharply and trigger much higher interest rates. That concern has turned out to be groundless, as I argued at the time; the Bank too expected to put rates up much less.
As argued above, the inflation concern is also misplaced today.
So the situation today is one where solvency is not an issue and inflation is expected to be low. Where then was the risk in pursuing a fiscal policy that supports the economy and avoids the damage to growth of raising corporation tax in this Budget?
This Budget was based on economic fallacies which are causing us big costs. It should be rejected as it stands and amended to stop the rise in corporation tax.