If Rishi Sunak had been under any illusions that the transition from economic support to fiscal sustainability would be politically easy, the chancellor was given a reality check this week.
His attempts to reassure Tory MPs that there would be no tax “horror show with no end in sight” failed to stop complaints that he was undermining the recovery and his planned autumn Budget could “stifle economic growth”.
Graham Brady, chairman of the Tory backbench 1922 committee, and Thérèse Coffey, work and pensions secretary, urged the chancellor to focus on growth and avoid tax rises even if they were not as large as foreshadowed in “tax bombshell” newspaper headlines earlier in the week.
The push back from within the ruling Conservative party chimes with the direction of economic thinking over the past decade which has become increasingly relaxed about unsustainable public finances at a time of economic weakness.
Some Tory MPs point to the fact that recent Treasury policies, such as a stamp duty holiday on house purchases and the “Eat Out to Help Out” scheme, had demonstrated that encouraging people to spend was the best way to speed the recovery.
The level of taxes is close to a postwar high in the UK and experts agree that any increases would depress output, incomes and spending immediately after they have been imposed. Edward Troup, former head of HM Revenue & Customs, said, “all taxes take something out of the system”.
The Office for Budget Responsibility has traditionally estimated the effects are small and temporary with a 1 per cent of gross domestic product (£20bn) increase in income tax or national insurance initially depressing economic output by 0.3 per cent (£6bn) before the economy regained its lost ground a few years later.
But the fiscal watchdog’s sanguine approach to forecasting the economic effect of tax changes has come in for criticism from increasing numbers of economists. They have warned the effects will be larger and more persistent when monetary policy struggles to offset tax changes because interest rates cannot be lowered or the depressing effects of tax rises cannot be partially exported because other countries are simultaneously following the same policy.
The IMF’s research over the past decade concluded that there was now “stronger evidence than before that fiscal multipliers are larger when monetary policy is constrained . . . the financial sector is weak or the economy is in a slump”.
Simon Wren Lewis, professor of economics at Oxford university, said it would be madness to raise taxes when the economy was weak and operating below normal capacity. Mr Sunak should only think about tax rises when the OBR was clear that the sustainability of the public finances were under threat and, even then, “only when interest rates start rising substantially,” he said.
If views about the short-term impact of tax changes have modified over the past decade, there is still a consensus that the government should aim to run sustainable public finances over the medium term, measured either by a stable or falling ratio of public debt to national income or a stable burden of interest payments as a share of tax receipts.
Nevertheless, few economists think sustainability would be possible without tax increases given that growth rates are forecast to remain depressed over the coming decade at a time of an ageing population and greater demand for high quality and resilient public services.
Torsten Bell, director of the Resolution Foundation, said this meant we should probably expect “a rerun of the tax rises of the 1990s than the spending austerity of the 2010s”.
A range of possible tax increases were mooted this week, ranging from a fuel duty hike to big increases in corporation tax. But tax experts said broad-based rises — such as higher main rates of VAT, income tax and national insurance — were the best way to raise large amounts of money with the least distortionary effects, especially if they focus on consumption rather than business costs.
But those would break clear Conservative manifesto commitments and other options are available to the chancellor.
Mr Troup identified corporation tax as one area despite the fact “traditional economic thinking points to VAT and does not point to corporation tax at the moment as the best revenue raisers.” He said the UK corporation tax rate of 19 per cent was low compared with most other developed economies that “it suggests there would be little effect of a couple of extra percentage points on the rate”.
Helen Miller, head of tax at the Institute for Fiscal Studies, said that the fundamental problem faced by Mr Sunak was that big new revenue streams were only likely to come from taxes that many people paid. “The smaller the group that tax increases are targeted at, the harder it is to raise large amounts of additional revenue,” she said.
She added that Mr Sunak had the option of exploring reforms to taxes that removed distortions in the system. She conceded extending VAT to all goods and services — a move that would raise £50bn a year — was probably a political non-starter. But she said the chancellor should look at the equalising the rates for taxing people’s incomes, which vary widely depending whether the money is taken as capital, self employment income or earned income.
“The UK government forgoes about £15bn a year by setting lower tax rates on the incomes of the self-employed and company owner-managers than the incomes of employees,” she said.