By Olivia Groom
Tax rises are on the horizon. Given the unprecedented levels of government spending to compensate for pandemic restrictions, the Chancellor has admitted “we have a responsibility, once the economy recovers, to return to a sustainable fiscal position.” The government has spent almost £300 billion to combat the virus, with debt surpassing 100% of GDPfor the first time since 1963. These are worrying figures: when public debt reaches 77% of GDP or higher, the debt begins to slow growth. Investors usually measure the level of risk by comparing debt to a country’s total economic output. The higher the debt, the more likely investors are to drive up interest rates in return for the increased risk of default. A higher cost of borrowing translates into components of economic expansion (such as housing, business growth, and auto loans) becoming more expensive. This, in turn, reduces spending and investing, decreasing aggregate demand, and thus causing a further decline in GDP. The fact remains that the government cannot uphold this catastrophic amount of spending and debt.
Increasing taxes may seem like as an easy way to reduce these negative effects of the government’s overspending. Indeed, the OBR projects that without further spending cuts or tax rises, this dangerous level of public borrowing will leave the UK with an annual deficit of 5% of GDP even once the pandemic has passed and the economy has recovered. Raising taxes is an effective way of allowing the government to provide funds for essential services (such as healthcare and education), without causing inflationary pressures. Especially in the current monetary environment with an extraordinary low interest rate of 0.25%, other than Quantitative Easing, there are few feasible options to encourage spending and business investment in the economy. Without this encouragement, GDP will fall even further.
However, raising taxes in the imminent future will be disastrous for an already floundering economy, which has experienced its worst GDP fall since 1709. It is fundamental macroeconomics that when an economy is in a recession and unemployment rises, the nation needs sustained deficits to raise demand and get the economy moving, as Keynes demonstrated. Now more than ever, the UK needs investors, firm owners, and wealthy households to keep their funds and businesses in the nation. By keeping taxes low compared to other countries who might rise their own, the UK could benefit further than this and encourage firms and the rich to move to the UK, creating a fantastic opportunity to stimulate economic growth.
Britain currently has the lowest corporation tax rate in the G7 at 19 percent. Upping this rate by two percentage points would be the most effective tax and raising £6.8 billion a year by 2024 (according to Government). However, this does not consider the loss of tax revenue by firms moving abroad, or indeed the soaring unemployment caused by this. Anil Kashyap, a U.S. academic on the BoE’s Financial Policy Committee, stated in 2019 that “to the extent that some of this flighty funding is going to the financial system and could be withdrawn at short notice, this could create cause for concern.” Brexit has caused 7,500 city jobs and $1.6 trillion dollars to leave the UK, according to EY. Meanwhile, it is reported that Sunak is considering a large increase in corporation tax from 19 to as much as 24 per cent. He is also deliberating on raising capital gains tax from 20% to a significant 45%. A one-off wealth tax could also be another option, but looking at neighbours’ experiences of introducing one, it is doubtful it would be successful. France’s wealth taxaccounted for less than 2% of French tax receipts in 2015, but contributed to a huge amount of capital flight with more than 12,000 millionaires leaving France in 2016. Now is not the time to be encouraging increasingly flighty firms and funds to leave the UK.
Other ways to raise revenue would be increasing taxes on households’ incomes or the self-employed or greatening stamp duty. The property market has been surviving on the stamp duty holiday, and indeed there are calls to scrap this tax altogether. Indeed, one of the reasons for the property market not crashing this pandemic thus far is the stamp duty holiday, with UK house prices rising 8.5% last year due to this. It is certainly not an advisable route to increase stamp duty now. However, it would be unfair to tax the self-employed, who have felt the impact of the restrictions more harshly than many other sectors. The UK Quarterly Labour Force Survey shows just over one million of the country’s self-employed workers are at risk of being affected by the lockdowns. On the other-hand, increasing all income taxes would impact the poor, who have been disproportionately hit by the pandemic, with 40% of workers on the minimum wagefacing a “high or very high risk” of losing their jobs. A progressive tax raise could be a possibility as long as the government is confident there will not be a significant amount of tax avoidance/evasion or capital flight. With the global economy estimated to have shrunk 2.9% in 2020, the UK might not have to worry about competition if most countries raise taxes to combat their spending against the economically damaging restrictions.
Despite being on course to borrow nearly £400 billion this year (19% of GDP), the government can more easily deal with this than expected, due to the extraordinarily low interest rate of 0.25%. Only after restrictions ease and the government secures economic recovery, will it have to balance the trade-off between cutting spending and a tax raise. No doubt some degree of austerity is inevitable, but taking into account inflation, the UK government can actually borrow at negative rates, reducing the need for an increase in tax revenue to finance the deficit and service the debt, even with levels above 100% of GDP. As long as interest rates are below the growth rate of the economy – a likely scenario considering the government will want to keep interest rates very low to encourage borrowing – economic growth will gradually causes debt as proportion of GDP to decline. If this is not allowed to happen, national debt will only increase compared to GDP. Therefore, the nation undoubtedly needs to focus on economic recovery instead of prioritising reducing the deficit.
Former Chancellor Lord Darling has warned Sunak against “choking off” the Covid recovery with higher taxes, and instead has suggested “it could be two or three years before taxes go up.” In a downside scenario public debt will grow at least 250 percent of GDP by 2050 if nothing is done to raise taxes or cut spending. In this case, tax raises will be needed to ensure a sustainable fiscal position. For now, it is evident the government should avoid tax rises in the near future to allow the economy to recover from a disastrous downfall.
The views expressed in this article are the author’s own, and may not reflect the opinions of the St Andrews Economist.