Patrick Minford is Professor of Applied Economics at Cardiff University
The British economy has had a torrid time at the hands of its recent governments. Before Labour took power from the widely despised Conservatives in the summer election last year Rishi Sunak’s Tory government had raised taxes relentlessly in the wake of Liz Truss’s resignation.
Corporation tax was raised to 25% and income tax was allowed to rise by failing to index the tax thresholds to inflation – a stealth mechanism that drove everyone’s marginal tax rates ever higher in the UK’s progressive income tax system.
These were policies that Ms Truss had vowed to prevent – yet her government plans were overturned by her very own officials and MPs in a frenzy of left-leaning opposition, as she has explained in her recent book, Ten Years to Save the West. In purely technical terms, the crisis in the government bond market that brought her down could have been averted had the Bank of England continued in its policy of buying in the market as it had been forced to do to defuse the pension fund crisis; but it in effect refused to do so, and so destroyed the Truss government.
Had Truss survived, the UK economy would have faced much lower taxes on business and top earners and entrepreneurs. The Tories might well then have won the election and presided over a successfully growing economy. It was not to be.
With the Tories’ overthrow has arrived the Labour government with an agenda even more hostile to enterprise, unfolded in the first Budget of Rachel Reeves, the new Chancellor, last October. It is hard to react to the budget aftermath with any equanimity. It is as bad as it gets.
The measures that were particularly ill-chosen were the rises in Inheritance (IHT) and capital gains taxes (CGT). These had a thoroughly damaging impact on small firms and family farms, and as the government’s own watchdog, the Office of Budget Responsibility, noted, could well have little if any revenue gain, once the indirect tax losses due to ‘behavioural changes’- ie. business closures and taxpayer departures.
The family farm sector is small but important for food supplies. The IHT effect on them is fairly devastating, as the tax will require farms to be sold off in parts to pay it. Much was made by Labour of their desire to hit wealthy purchasers of land for capital and IHT avoidance. However, a wealth tax on land has never gone through Parliament in spite of much support from economists over more than a century; IHT on family farms was never going to succeed in hitting such wealthy owners, who can dispose of their land and move abroad, adding to the entrepreneur exodus.
Then one turns to the small business sector. Here it seems the Treasury needs reminding that this sector accounts for around half the economy’s employment. Furthermore, it is a key part of our entrepreneurial sector, where we hope to see productivity growth. Any such activity will be destroyed by the huge disincentive of IHT, requiring firms to be sold off in bits to pay the tax, effectively destroying the business. It was precisely to avoid this that the Small Business exemption from IHT was brought in 1976.
What, we have to ask, was the motive for including these damaging measures in the budget? Since they probably reduce overall revenue, it seems it could only be some vindictive class-warrior thinking, such as also inspired the levying of VAT on private schools. Yet for a party that aspires to a wider appeal in future elections such thinking is surely a big mistake.
Then we come to the main revenue raiser – the NI increase on employer contributions, including a big lowering of the threshold. This was done in order to meet the new fiscal rules: that the current budget must be balanced and that public sector net financial liabilities must fall in the fifth year ahead.
In the present weak state of confidence after a long period of high interest rates, this measure has been deflationary; vacancies are already falling, apparently quite sharply, and recession is likely. With this further depressing wages and prices, the chances of interest rates falling have mercifully but belatedly increased – more below on this.
This will lower government bond yields and raise bond prices. The government could have kept NI constant without triggering the ‘market rout’ so clearly feared by the Treasury. Accompanied by active Bank intervention there would have been little risk of rising yields. It was, as explained above, the absence of such supporting intervention during Truss’ time that destroyed her government.
What can Labour do now to retrieve the situation? The measures that cause the real damage to our entrepreneurial culture, so painfully rebuilt by the Thatcher reforms of the 1980s, are those that levy high marginal tax rates on small business (including small farmer) incentives and also high marginal tax rates on businesses generally: these are the rises in IHT and CGT.
Can the UK break out of this doom loop where zero growth means worsening finances due to sagging tax receipts and rising spending needs?
As they raise little if any revenue, they can be repealed without affecting the fiscal rules. Reversing these changes would do much to restore growth prospects. Further moves of the same sort would be cancelling of the VAT on private school fees and the abolition of the top marginal income tax rate of 45%; the former raises little if any net revenue and the latter probably reduces revenue so these changes would overall be likely to increase revenue.
By these moves the Labour government would improve its relations with business and get closer to its intended pro-growth stance. In the short run it would boost business confidence, so badly hit by this budget.
There is more and once again it concerns the Bank of England. The Chancellor, Rachel Reeves, is going around telling regulators to support growth. After all that damage she did in her budget by raising a wide range of taxes on business and ‘the rich’ (ie. the entrepreneurial class), her belated change of tone is welcome. But growth prospects have disappeared and much more than this is needed to revive them; she could start by reversing the worst of those taxes, as we have just explained.
However, deregulation is certainly needed too. Anything this government can do to reduce the dead hand of endless delays to infrastructure and house building from regulators and their nimby protagonists is much to be welcomed., and its ministers now seem to be trying.
Nevertheless the behaviour of the most damaging regulator of all, the Bank of England, needs highlighting but has so far not been mentioned. It has been given powers to regulate financial markets by setting interest rates and also the rules of its own market intervention. It has wielded these powers in a way that is badly damaging growth.
That damage is hiding in plain sight, and it is striking how little attention it is receiving. It is time to put the spotlight on it and discuss how it can be stopped. There are two main aspects to this: first the Bank’s balance sheet and second its interest rate decisions.
Take the balance sheet first. Much play has been made of the capital losses the Bank has sustained on its disposal of the government bonds (gilts) it bought as part of its ‘Quantitative Easing’ (money printing) programme, the APF (Asset Purchase Facility). However, this is a red herring because those gilts are liabilities of the government which made an equal and offsetting capital gain on them as their market prices fell; hence for the public sector as a whole the price changes on these gilts wash out.
The balance sheet problem lies not there but in the treatment of the bank reserves into which the money the Bank used to buy these gilts is converted by the commercial banks where it was deposited. Under the intervention rules the Bank has instituted, it pays the going short-term interest rate on these reserves, arguing that this is necessary to prevent those banks from using them to buy short-term market bonds and so force down the market interest rate.
Yet this is costly to the public sector and so the taxpayer: on the £700 billion of outstanding bank reserves current nearly 5% interest rates mean a taxpayer cost of about £30 billion, 1% of GDP, and roughly double the £15 billion net to be raised by the budget’s NI employer contribution rise.
Yet it is far from ‘necessary’ for the Bank to act in this way. It is possible to make bank reserves largely compulsory, with no interest payable, and simply to pay interest on a small tranche of ‘excess reserves’ above this. These excess reserves could then be used to make loans to bank customers, with banks prevented from investing them in short-term market assets like Treasury Bills.
Systems like this were generally in use by major central banks before the advent of the large QE programmes since the financial crisis. They could easily be restored today, so saving large costs to the taxpayer.
Essentially, the new bank regulative practices have voluntarily converted money liabilities of the public sector into interest-bearing debt, so giving up the ‘seigniorage’ revenue the government gets from issuing money instead of debt. Bank reserves are simply money converted into deposits at the Bank; there is no obligation on the Bank to pay interest on them any more than it pays interest on bank notes.
It is astonishing that this has been allowed to go ahead with virtually no pushback from the Treasury, the Conservatives when in power (apart from Liz Truss who asked for an inquiry into the Bank’s actions) or now Labour. Only Reform, supported by a few lone voices, have attacked this practice, pointing out that it is transferring seigniorage to the banks as a massive windfall subsidy.
Now turn from the Bank balance sheet costs to its policies in setting interest rates. Here it has stubbornly refused to lower rates, helping to cause the current threat of recession. It is a central point in monetary theory that inflation follows the growth in the money supply with some lag, usually about eighteen months but with some variability – what the late Milton Friedman, the influential monetarist, termed ‘long and variable lags’.
This is a well-established correlation brought about by the lowering of interest rates when policy eases; this creates the expansion of demand, paid for by credit and so money creation. Over time this creates inflation, with prices typically leading wages. We have seen this painfully in action as inflation soared after the Covid period of money creation.
Vice versa, as policy tightens money growth slows and later so does inflation. Typically again the lags mean that wages may lag prices. The key point lies in these lags; it makes no sense to react to individual elements in the process, like wages or service prices, with further interest rate adjustments.
However, money supply growth has not merely fallen back but actually went negative about a year ago, before recovering to low growth currently, signalling that policy greatly over-tightened. The correlation of inflation with money growth implies that inflation may now overshoot to become negative, with the economy going into a bad recession. In ignoring this correlation the Bank is seriously undermining growth and putting the economy into a risky situation, which has only been worsened by the budget’s attack on business and entrepreneurs.
The Bank’s defence is that its model of the economy identifies shocks that can cause future inflation. But while this may be true, it can only do so in retrospect; this is like weather models which can chart past shocks and how they propagated, but a forecaster of weather will rely on its correlation with the fronts that are already on the radar and due to land here after the usual lag.
The IEA thinktank’s shadow monetary policy Committee which bases its views on the money-prices correlation has been urging interest rate cuts for months now since money growth collapsed. The Bank keeps saying there is a wage growth shock threatening resumed inflation; but wages are simply lagging in the falling inflation process.
The Bank of England was given independence in setting its rules of regulatory intervention. But among all the regulators we have it is probably the worst offender in damaging growth. It above all needs to adjust its behaviour.
The Labour government, which has managed to become deeply unpopular in the few months since the election is now trying to ‘reset’ its policies into a ‘pro-growth’ mould. If it was serious about this, it would cut back public spending from its currently projected 45% of GDP and cut back taxes with it.
The problem for Labour is that public sector unions are its main paymasters, while its MPs are deeply reluctant to cut benefits which are running at 11% of GDP, with fast-rising claims for illness out-of-work benefits. Departmental current spending is 16% of GDP, and productivity has fallen 9% since pre-Covid according to the Office of National Statistics.
Rachel Reeves has started to talk tough on these issues but Labour is plainly less likely to tackle them than the Tories who were the ones to let them drift out of control. With public sector receipts only 42% of GDP, there is a persistent gap in the public finances pushing this government towards even higher taxes, dooming growth prospects still further.
Can the UK break out of this doom loop where zero growth means worsening finances due to sagging tax receipts and rising spending needs? The last time the UK took serious remedial action was under Mrs Thatcher. Today the Reform Party is rising in the polls, putting forward similar reforming policies, while the Conservatives are apologising for the decade of drift they presided over. Hopes for a better UK future depend on these two forces coming together to cause a sharp change of UK policy direction.