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 package to help families meet rising energy costs. The financial markets instead of cheering tax cuts announced, 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 which houses the world’s biggest global financial centre.
There are more such anomalies. The Conservative Party has been running the government for the past twelve years. Yet, contrary to the image of conservatives who stand 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 lead to a boost to economic growth. Or maybe she believed that cutting taxes would increase tax revenue, a view attributed to supply side economists.
The now ousted Chancellor’s proposal was to reduce the top tax bracket from 45 to 40% and reducing overall taxation from 20 to 19. Even corporate tax rates were to be kept and 19 and not move to 25. The problem was that bulk of the tax gains, nearly half of it was going to the top 5 percent 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 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%, which India had in the 1970s. But when marginal rates are around 25%, the phenomenon of the Laffer Curve (named after Arthur Laffer who propounded the theory of tax cut leading to increase in tax revenue) is unlikely to work.
The proposed tax cuts by the Truss government were thus the most drastic ones in the past 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 increase in fiscal borrowing got a thumbs down from financial investors. You can’t fool the 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 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 selloff. This was spinning out of control, and the government of the UK had to step in to avert the bottomless fall. This intervention was to the tune of 62 billion pounds, which would be unheard of in a developed country. 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 historic high of 10%, 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. The new Chancellor has his work cut out. Even the Prime Minister may lose her job if the instability continues.
The lessons to learn from the UK crisis are as follows. 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 which India’s Finance Minister also has indicated as a possible guidance about India’s forthcoming Union Budget in January. 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 selloff 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 quick learner!
Dr Ajit Ranade is a noted economist
