High inflation means we do have scope to cut taxes

It has become normal for commentators to wring their hands over the government’s fiscal position and pronounce it impossible to go ahead with any tax cuts.  The latest to do this was the IFS last week. They cited the huge rise in debt interest as the basic cause of this “unsustainability” in the public finances.

However, there is a massive fallacy in these pronouncements. They fail to take account of how inflation affects the position. Inflation reduces the real value of debt and lowers the real rate of interest. At the recent rates of inflation we have seen, it has massive effects on both real debt and the real interest rate, largely transforming the picture of doom and gloom into a manageable short-term issue, making it quite possible to cut tax and so simulate the long term growth that besets our long term prospects and with them the long term fiscal position.   

The usual way the UK’s public finances are reported is in money terms. This includes debt interest which also contains the inflation element on index-linked debt.  However, the true cost of public debt is the resource cost to taxpayers. This is the money cost of taxes divided by the consumer price index. The latter measures the money cost of one unit of consumption; this in turn is what the consumer sacrifices in utility by giving up this unit. So when we measure public spending and taxes, we should convert them into resource costs to taxpaying households by dividing their money costs by the consumer price index, the CPIH published by the ONS.

This resource cost of the public finances tells us what these finances imply for the amount of resources that need to be taken from households by the government now or in the future by paying off future debt. By contrast the usual accounts in money terms are used to calculate money debt which is then usually expressed as a percent of money GDP, whereas the former real resource quantities are expressed as a percent of real GDP, the real resources available, i.e. money GDP deflated by the GDP expenditure deflator, which is the cost of spending UK income, roughly equal to the CPIH. Money GDP is real GDP times the GDP deflator which is the home cost of production, a totally different deflator.

We can illustrate what this all means in practice by doing the accounts in two different ways. We do this below, first showing the traditional accounts in the OBR’s presentation, and then redoing them in real resource terms, for 2022/23 and 2023/24, the current and next financial years. In the Table below we show the traditional accounts in money terms and then in resource terms in 2022 prices.

What these figures show is that real debt interest at recent inflation rates has been negative. This reflects the fact that inflation has exceeded nominal interest on non-indexed debt and on indexed debt has roughly equalled the ‘inflation interest’ (not exactly because indexing is to the RPI which differs from CPIH). From 2024/25 real debt interest rises somewhat as inflation falls, while nominal interest rates remain quite high; nevertheless, the real interest rate remains subdued at around 2%.

Furthermore, the market value of government debt has fallen by nearly 40% since 2020, due to rising gilt yields — see chart below. This has lowered the debt/GDP ratio in current market value. Essentially, this arises because the DMO/Treasury managed to sell most of existing gilts at low interest rates prevailing during Covid; hence the market currently values these about 10% lower than face value.

What these figures show is that in resource terms debt is falling relative to GDP, and more so than in the normal calculations done first in money terms and then divided by nominal GDP. The basic reason is that the proper calculation uses the CPIH to turn the money accounts into resource terms; dividing everything by nominal GDP effectively gets to the same debt ratio but only if the price index for nominal GDP, the ‘GDP deflator’- which measures the cost of home production- is the same as the CPIH. In the long run this will be true, as wages and capital goods prices, the two costs of production, catch up with the CPI. But there is a lag which makes things currently look much worse than they truly are: in the calculations above the GDP deflator used lags the CPIH by 6%. This bias to gloom is further worsened by the usual failure to allow for the effect of falling gilt prices on debt value.  Correcting both of these gives you the correct real resource calculation for the debt ratio of less than 80%.

When the corrections are made, we can see that the debt/GDP ratio is far better than as currently being bandied about. Tax cuts are clearly feasible while still reducing the debt ratio over the next few years- the focus of the short-term ‘fiscal rules’.  But there is a further strong long-term argument for tax cuts.

Without them we will get zero growth, which implies that the current fall in the debt ratio will reverse so that the ratio gets steadily higher as tax revenues stall, threatening long run solvency. The way to avoid this is to spur growth with lower taxes, as well as other pro-growth policies; and to ignore any resulting short-term rise in debt as both affordable within the short-run fiscal rules and ultimately reversible by rising tax revenues. It is time to reject the bias to gloom in current fiscal commentary.

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