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Tax cuts: avoid short-term thinking

    The political events of the weekend have been significant. For the first time, Ed Balls shifted from talking about the need to reverse ‘savage’ spending cuts and instead is now calling for ‘tax cuts’ to stimulate the economy. He has loosened his position away from simply calling for a VAT reversal and suggests Labour would support cuts to the basic rate of income tax or increasing the income tax personal allowance more quickly. With the Liberal Democrats also pushing for a rise in the personal allowance to £10k this year, the intervention by Balls throws down a significant challenge to the Chancellor. When we teamed up with ComRes in October, we found that, if forced to choose, 47% of the public would like tax cuts to try to stimulate the economy, compared to 34% who wanted more public spending. The key question is: where would tax cuts leave Osborne’s strategy?

    After the first Emergency Budget in 2010, most believed the Chancellor would do all he could to eliminate the structural deficit by the end of the Parliament. Since then, the OBR has revised up its estimates of the size of the structural deficit and have lowered growth forecasts. At the time of this revision, many of us at the CPS, in addition to Lord Flight, said that Osborne should have stayed ahead of the curve by cutting further, sooner, to maintain the deficit target. Instead, Osborne decided to stick by his spending plans and roll the target forward into the next Parliament. It remains to be seen whether this was a wise move, but what the Government is likely to regret is the way that almost all of the closure of the deficit undertaken so far has come from reductions to capital spending and tax hikes. The IFS showed in their Green Budget just 6% of the contribution of current spending to the structural deficit closure has been achieved so far.

    It clearly would have been less harmful to short-term growth to have front-loaded the current expenditure cuts and delayed the tax hikes and capital spending cancellations. But, we are where we are. With growth still sluggish, the Chancellor will face increasing pressure over the coming weeks to do something in the Budget. But it’s important that he doesn’t engage in another round of small, populist give-aways as we saw in the Autumn Statement, and even more important that he resists the urge to make temporary tax cuts to incentivise consumption spending. What we need is a focus on the medium-term, and we can set out a path to sustainable growth based around savings and investment.

    Suppose the Chancellor decides he has scope for tax cuts or rebalancing. I’m going to assume that the aim here is primarily to increase the UK’s growth rate rather than to ease the pressure on families. To this end, temporary VAT cuts should be avoided. Not only does VAT provide significant revenue, making cuts expensive, but temporary cuts have been shown to have distorting effects for retailers and unclear effects on actual retail prices. What retailers really need is certainty of the rate for the remainder of the Parliament. Broadening the base could be a means of lowering the rate, but the regressive effects are likely to make it politically infeasible. But the most important point about VAT is this: if we really want our economy to rebalance towards saving and investment, it would seem futile to attempt to encourage temporary consumption. VAT cuts could boost growth in the very short-term, but this sort of short-termism should be avoided.

    Temporary National Insurance holidays have also been shown to be ineffective. Firms tend to make hiring changes based on longer-term considerations. Both of the above tax cuts would therefore be popular, but not particularly helpful to medium-term growth.

    The problem is, the most effective tax rate cuts for raising the medium-term growth rates are the most unpopular: things like corporation and capital gains taxes.

    In the long-term the health of your economy is determined by the efficiency of the use of resources you have and your ability to attract new ones. Any scope the Government has for tax cuts should therefore be permanent reforms of corporation, capital gains, and income tax. These are the tax reforms most likely to improve growth to the extent that they are self-financing in the medium-term, as evidenced by an OECD study in 2008.

    The CPS has focused in recent weeks on cutting Corporation Tax to 20%. This would not be particularly costly, even in the short-term, but would boost business confidence and would send a strong signal that the Coalition is taking the supply-side measures necessary to restore growth. It would also immediately fulfil the Coalition pledge to “create the most competitive corporate tax regime in the G20”. Some have said to us that it makes little sense to do this, because companies are already sitting on cash surpluses. But what better way to get them investing than by significantly increasing their rate of return after tax? This simple reform would actively encourage companies to invest their cash in new ventures.

    Continuing to raise the personal allowance is also a noble aim, but it’s unclear whether the cost might rule out a move all the way to £10k in this Budget. I, like many conservatives, would prefer to see deeper cuts in spending to enable bigger cuts to marginal rates across the board, but given this is unlikely the Chancellor should prioritise the increase of the PA.

    For other taxes, it seems that we might already be on the wrong side of the Laffer Curve. John Redwood has done lots of work to show that receipts would probably increase if capital gains taxes were reduced; meanwhile, I remain convinced that the 50p rate is unlikely to be making the Treasury significant revenues, when all secondary effects are considered.

    Some will, of course, say that the Government can’t afford any of these tax cuts, because of the short-term loss of revenue. But this argument is disingenuous and only works if one assumes that every single current tax and spending decision is set in stone. The reality is different. Even putting aside the beneficial dynamic effects of targeted tax cuts, they could be funded now if the Government changed its political priorities, reducing spending elsewhere if necessary or broadening the base of taxes and eradicating complicated reliefs and exemptions. It’s time to reform the supply-side of our economy for its long-term health: significant deregulation and targeted permanent tax cuts in the Budget are desperately needed, even within Plan A.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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