Central banks have made progress in fighting inflation, but new challenges arise. Political leaders may be tempted to appease voters in election years, risking inflation. Tax cuts in the UK come as the Bank of England gains control over inflation, bu...
Troy D. Hanson
November 30, 2023
Central banks have made significant progress in their fight against inflation, but new challenges lie ahead. One such risk is the temptation for political leaders to appease voters in an election year.
2024 won't only bring elections in the United States; over half of the global population resides in countries holding elections next year, as reported by Deutsche Bank. In the United Kingdom, the Conservative government has kick-started its campaign by introducing a series of tax cuts for businesses and millions of workers. Prime Minister Rishi Sunak, lagging behind in the polls, is betting that these tax cuts, amounting to approximately £20 billion ($25 billion), will boost voter sentiment without stoking inflation.
These cuts, announced on November 22nd by U.K. Finance Minister Jeremy Hunt, come at a time when the Bank of England is finally gaining control over inflation. In October, U.K. consumer prices increased by 4.6% on an annual basis, down from 6.7% the month before and a peak of 11.1% in October 2022.
The question arises: will the government's fiscal plan succeed in winning over voters? Doubts remain. The impact of these tax cuts may not be substantial enough to sway voters who have thus far shown strong opposition to the Conservatives. Additionally, the government's official forecaster expects these announced tax cuts to contribute less than 0.3% to the gross domestic product until 2028-29.
When put into perspective, this boost appears relatively meager. In fact, the government forecaster recently downgraded the GDP growth forecast for next year during the election period from 1.8% to a mere 0.7%. Furthermore, looking ahead to 2025, growth is projected to increase to 1.4% from a previous estimation of 2.5%.
Despite reducing the main rate of National Insurance (a tax paid by employees on their earnings) from 12% to 10%, the government's decision to freeze personal tax thresholds means that the overall tax burden continues to rise.
The Impact of Tax Cuts on the Bank of England and Public Finances
Recent tax cuts in the United Kingdom may have unintended consequences on the economy, including the need for the Bank of England (BOE) to adjust its interest-rate plans. If these tax cuts stimulate consumer spending and subsequently lead to inflation, the BOE may be forced to reconsider its existing forecast, which projects inflation to reach its 2% target only by the end of 2025.
According to Paul Dales, chief U.K. Economist at Capital Economics, these tax cuts have provided a short-term boost to GDP growth, but they might result in an extended period of high interest rates. Dales raises concerns that this trade-off could impact the economy in the long term.
While tax cuts can yield immediate benefits, they also pose a long-term challenge. The funding for U.K. public services is already strained due to inadequate adjustments for inflation. Further cuts could exacerbate the situation, putting pressure on public finances. Although this may not directly affect the current Conservative government, it will eventually escalate borrowing costs in the country, as interest rates continue to rise.
Sanjay Raja, chief U.K. economist at Deutsche Bank research, emphasizes the importance of prioritizing supply-side measures to enhance economic growth potential over time. Given the limited scope for spending in the U.K., Raja suggests that prudent fiscal policy should focus on measures that facilitate sustainable growth.
This situation in the U.K. offers a valuable lesson for U.S. lawmakers who are preparing for the 2024 presidential election. It serves as a reminder that tax cuts, while appealing to households and businesses, can have repercussions on monetary policy. Lawmakers from both political parties need to consider the potential impact and the widening federal budget deficit when proposing tax cuts.