Don’t raise taxes, don’t kill the recovery

This is Iain Martin’s newsletter for Reaction subscribers.

On Wednesday the Chancellor will deliver his next Budget. The run-in has been extremely strange, characterised by briefing upon briefing suggesting tax rise after tax rise. The mantra reported in numerous well-sourced stories has been that the Treasury is determined to close the Covid deficit and to start repairing the public finances now by increasing taxes.

What is going on? Theoretically, Rishi Sunak is supposed to be an instinctively low tax Conservative who likes enterprise, deals and dynamism. The idea that he will choose this moment to pile tax rises onto a bombed out economy mid-Covid seems bizarre, almost unreal.

There may be a degree of double bluff involved, of course, to make what he eventually announces look less punitive. Chancellors relish the rare sense of power and preeminence that comes from making a Budget speech. It makes for a neat rhetorical device to say that they have “resisted calls” for this that or the other change, and then announce a smaller tax rise than briefed in advance.

It doesn’t look like a bluff this time though. There is too much of it leaking, particularly on the question of corporation tax, where the repeated suggestion is that because the Biden administration is set to hike business taxes then there is cover to do it in the UK too. This is a terrible argument for doing anything.

The US administration is about to embark on an extremely risky economic experiment, borrowing yet more to launch a $1.9tr stimulus, involving $422 of direct payments, $246bn in jobless assistance and $350bn for states and local governments struggling with low tax revenues.

Doesn’t the economy need a boost? On one level it sounds like it makes sense, but not much.  The US economy has little need of artificial stimulus; it needs reopening so that private wealth accumulated in the crisis can be deployed on spending and investment. What is holding this back is the virus, not a shortage of government spending.

Mercifully, vaccination is well underway in the US, unlike in the EU. As of this week, 70.5m does have been given in America. More than 1.4m doses are being delivered per day on average.

The danger of a vast stimulus now – scattergun, misdirected, fought over by state-level politicians scrambling for a slice – is that it is a straightforward misallocation of resources and a distraction from letting businesses and individuals roar back to create jobs. It is topsy turvy to borrow more for stimulus while raising taxes that inhibit growth, when growth is the only way to create a solid and growing base of tax receipts. There is another risk, that it might have unsettling inflationary impacts in a couple of years time. As Simon Nixon put it in The Times this week, before every major inflationary shock in modern history hardly anyone predicted it, and then it happened.

In Britain, the pre-briefing suggests the Treasury’s intentions are Bidenish on the tax front.

This has profoundly unnerved many economists and also senior Conservatives, although Tory MPs are strangely quiet. Several free market think tanks, including Margaret Thatcher’s Centre for Policy Studies, have pointed out that tax rises are the last thing the economy needs now. David Cameron, in a too rare intervention, warned that it made no sense to raise taxes at this moment. The risk is that the added burden will suppress the recovery that is waiting to burst out when even a partial reopening of the economy occurs.

Raising taxes at this point, particularly on business and investment, would be extremely dangerous when confidence is essential. Hundreds of billions of pounds accumulated by savers and the healthier parts of the private sector await deployment, within months, as investment and spending. As it floods out across the economy, via millions of individuals operating in the magic of Adam Smith’s market economy, some of it will be spent on goods and services that boosts employment, and then tax revenues. It is the ultimate virtuous circle of the kind Conservative chancellors are supposed to recognise instinctively.

This is not a situation analogous with the early 1980s, when Thatcher and her Chancellor Geoffrey Howe did raise taxes in tough circumstances. They were attempting to restore order to the nation’s finances in a madcap inflationary climate with British industry in a state of collapse (the situation then got, for a while, even worse.)

Today, the key is to not get in the way of a recovery. Stand well back and let private enterprise surge. Once six months to a year has passed we’ll see what the impact is on restoring growth and with it tax receipts and the size of the deficit. Until then, the government is getting its debt away incredibly cheaply (for now) and should be able to wait, to judge what is needed in terms of the public finances and taxation this time next year.

There is also the question of domestic business investment and foreign direct investment. Britain with its productivity problems needs the former, and if Brexit is to be made to work well it needs a surge of the latter too. If the US is going European, opting for a higher tax environment, then the gap for Britain is to become a magnet for investment and capital. Increases in corporation tax or capital gains tax would send entirely the wrong signal. Why discourage business and entrepreneurs?

Michael Devereux of the Oxford University Centre for Business Taxation this week urged the Chancellor to be cautious about raising the corporation tax rate. Devereux says: “A consensus estimate is that inward foreign direct investment falls by 2.5% for every one percentage point increase in the corporation tax rate. Roughly, then a 4 percentage point rise in the tax rate would reduce inward investment by 10%. That would be unwelcome, to say the least, at a time of a very significant downturn in the economy.”

As he points out, the public tends to misunderstand this, assuming taxes on business have no impact: “Taxes on business must ultimately fall on people as well – shareholders, consumers, employees and suppliers; with taxes on business it is just more difficult to figure out which people are more affected.”

We’ll see on Wednesday whether Sunak understands this, or whether he produces some hybrid, with some tax rises and windfall levies balanced with wheezes and allowances.

How much, if any, of this argument has penetrated Number 10 and the Prime Minister’s brain remains a mystery. The truth, and he would admit it, is that economics has never featured much either in his writing or as a political preoccupation. The main focus now in the mediaeval court of the Johnson premiership does not seem to be the importance of generating economic growth. In Borisworld the economy just sort of happens; very wealthy entrepreneurs exist in the form of donors who serve good wine; and business trundles on doing its thing always finding a way through despite the political circus. He is pro-dynamism in the economy as he is pro-dynamism in every other regard, enthusiastically but vaguely. The notion that he should think much about the detail of the economy or the impact on business would strike him as silly. Remainers will say this was apparent in the way he viewed the Brexit negotiations too.

That leaves the Chancellor. We can but hope that Sunak has resisted the worst of what the Treasury is recommending. The sensible position right now, pre-reopening would be to do no harm as the medics say. Do very little as the patient, the economy, takes its first post-lockdown steps out of bed.