Inflation and tax cuts. Ultimately, monetary policy matters more than tinkering with tax thresholds.

22 Jul

This morning, Radio 4 listeners had an insight into a topic we will be hearing much about in the next few weeks: Trussonomics. According to the Foreign Secretary, her planned tax cuts will decrease inflation, boost growth (thus preventing a recession), and will increase government revenues.

This virtuous assortment of free-market goodies would, Truss hopes, see Britain out of a decade of anaemic growth under her premiership  – and see her back into Downing Street in 2024. The trouble for Truss is that is not everyone is convinced that it will work. It therefore deserves asking: how inflationary are tax cuts likely to be?

Chris Giles of The Financial Times is one of the voices at the sceptical end of the spectrum. In a Twitter thread today, he went through the flaws he sees in Truss’s proposals. Essentially, Giles argued that her touted cuts to National Insurance and Corporation Tax – designed as a supply-side boost – would also increase demand, even if doing so might improve business investment and employment in the longer-term.

The problem with this, to quote Giles, is that “the demand comes first, the supply later”. More business investment and employer NI cuts would increase demand amongst employers and businesses without matching it with supply, primarily due to our still shortage-ridden economy and the problem of long-term sickness hampering our labour supply.

Giles went on to say that since the Bank of England think there is little spare capacity – essentially, a business not making full use of its available supplies and manpower – this increase in demand will lead to higher interest rates. A sharp rise in rate would choke off the investment that Truss hopes for. Similarly, any inflation caused by a Barber-style dash for growth – a Kwasi Boom, anyone? – will cause the Bank of England to raise rates faster.

The sum of this, for Giles, is that (“at a time of low unemployment and record job vacancies”) we need the economy to have lots of spare capacity for Truss’s proposals to work without boosting inflation and causing a jerk rise in rates from the an independent Bank of England that does not agree with the Foreign Secretary’s basic assumptions.

Giles has been equally critical of Sunakonomics so far, on the justifiable grounds that it is a hard-headed approach predicated on growth breakthroughs that the ex-Chancellor has yet to elucidate beyond his MAIS lecture. Yet his thread on Truss will be welcomed by the Sprite and sun cream enthusiasts at Rishi HQ.

But has Giles been too pessimistic? Julian Jessop, for example, is more sympathetic to the Truss approach. He makes the helpful point that which tax you cut impacts its effect on inflation. Cutting VAT and Fuel Duty, in a revenue-neutral way, could reduce inflation by cutting the prices of goods and fuels. More specifically, the Foreign Secretary’s proposed cuts in NI and Corporation Tax would encourage investment, which would produce the productivity growth and saving that produces deflation in the medium-term.

Now, Giles did not dispute that investment can produce inflation. But where Jessop differs from Giles is in his suggestion that the impact of the cuts – even if inflationary – would be small. And that a tighter monetary policy, if not friendly to immediate growth prospects, would be no bad thing. It is Cakeism, Jim, but not as we know it.

I certainly agree with Jessop on the latter point (and that there is some slight hypocrisy in Sunak opposing further tax cuts now, whilst pressing ahead with the cut to the National Insurance threshold earlier this month). Yet I think both he and Giles have missed a central problem.

Truss told The Spectator earlier this week that she wants “a tougher Bank of England mandate”. This the Bank’s target – set by the Treasury – to keep inflation around 2 percent. It has not been very good at this. Since the target was first missed in 2007, as Andrew Lilico has pointed out, thirty letters have been written by Governors of the Bank to the Chancellor explaining why they failed to do their job. So for those of us of the view that our current inflation is a combination of various supply shortages exacerbated by huge monetary expansion, a bit of tightening is long overdue.

But, as James Forsyth has noted, the Bank of England shows no sign of moving from a policy of small rate rises. The Bank is trapped by caution and groupthink. A member of the Monetary Policy Committee (MPC) – which makes decisions over interest rates – has already attacked Truss for challenging its orthodoxy. But it is that same orthodoxy that has kept monetary policy too loose for too long – and why inflation is surging past 11 percent.

So changing the Bank’s mandate should be a priority for both candidates. The independence of the Bank of England – for all the good it may have done Gordon Brown’s economic credibility – has failed to act as the bulwark against inflation that proponents of the idea long hoped for. As Jessop has written, the Bank’s independence has apparently raised it above criticism – but that it should be criticised does not prevent it from acting in its own misguided way. It was a Labour Chancellor who gifted the Bank its independence; maybe it was time a Tory one took that present back.

For the moment, though, the answer is simpler. Combining £30 billion in immediate tax cuts alongside a relatively loose monetary policy would be inflationary – but it depends on the taxes cut, and the effects that has on demand. But what the next Chancellor does in tinkering about with tax rates will be rather less important for current and future inflation than whether the Bank of England finally gets its act together. So whilst voters would surely appreciate having more money in their pockets, it would be pointless if the gains were wiped out by monetary laxity.

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