Is cutting UK taxes ahead of a general election affordable or not? An economist explains

A Conservative government considering tax cuts^[1] a few months ahead of an expected general election may not sound very surprising. Tax cuts are understandably popular – especially when household incomes have been squeezed by high inflation^[2] and rising interest rates.

But can the British economy afford them? Recent figures on UK borrowing led some analysts to suggest that it can^[3]. Those figures showed^[4] that government borrowing fell to £7.8bn in December 2023, £8.4bn less than a year earlier, apparently giving chancellor Jeremy Hunt some “headroom” to announce tax cuts in his budget in March.

But then came warnings that the chancellor should not get carried away. One thinktank, the Institute for Fiscal Studies commented: “Tax cuts today add to the risk of tax rises or spending cuts tomorrow.” The IMF weighed in next, advising that tax cuts should be avoided. Eventually Hunt also appeared to concede^[5] that they may not be on the cards.

So is the headroom there or not? Is one month of lower borrowing enough to counter the longer term problems faced by the UK economy?

For some of those problems have been around for quite a while. Ever since the global financial crisis of 2008, the UK economy has been grappling with stagnated productivity^[6] and declining wages^[7].

Then came the pandemic which was a big blow to the economy^[8]. More recently, supply chain disruption and the war in Ukraine have driven up inflation^[9].

Unsurprisingly, all of this led to a sharp reduction in consumer confidence which has been on a downward trend^[10] for years.

Any incumbent government facing a general election would be concerned about these factors. In the autumn statement last year^[11], the government announced significant changes in the tax rates in an attempt to boost consumer confidence and increase their purchasing power.

And now that inflation has fallen^[12] fairly significantly (though remains above the 2% target) there is a general expectation that the Bank of England will start to cut interest rates.

As well as reducing mortgage payments for many households, this would also reduce future borrowing costs for the government, giving them some room to cut taxes in a bid to boost growth in the economy.

But not all types of tax cuts stimulate growth. It depends on how they are funded.

If cuts are financed by borrowing, they are likely to lead to serious repercussions for the economy^[13] (just ask the former prime minister Liz Truss^[14]). But tax cuts driven by spending reductions – such as less money going on government borrowing debts – can have a positive impact.

Evidence suggests^[15] that the growth effects of lower personal taxes – such as income tax and national insurance – are most visible in stimulating higher demand for service sectors such as transport, construction, accommodation and hospitality.

Personal tax cuts would also have the simple but attractive benefit of giving workers in any sector a bit more money in their pay packet. After years of incomes being squeezed by global events, frozen tax thresholds and generally higher bills, that would provide some financial respite for millions of households – and improve confidence.

But increasing labour productivity in the UK is the single most important thing^[17] to do to secure a better economic future. One of the reasons for stagnated productivity in UK has been very low rates^[18] of investment in the UK compared to the G7 countries.

And there is actually some good news on that front. In the last two years, investment growth was faster in the UK compared to other G7 countries^[19], partly thanks to a government scheme^[20] launched in 2021 which allowed businesses to significantly reduce their tax liability.

This lets companies deduct 130% of their investment in business equipment (known as “plant and machinery”) from taxable income. Globally, it’s a very competitive system which has shown promising results. Anything which makes the UK an attractive destination for global talent and investment may help increase labour productivity too, which would further increase consumer confidence and economic growth.

In the meantime, many people may still be hoping for new springtime personal tax cuts, and arguing for their benefits – both in the immediate future and further ahead. But to get those, the government would really have to make sure they are accompanied by a credible expenditure reduction plan, laid out in a government spending review. And the next one of those is not expected until April 2025^[21].

References

1. ^{^} considering tax cuts (www.bbc.co.uk)
2. ^{^} high inflation (www.bankofengland.co.uk)
3. ^{^} suggest that it can (www.theguardian.com)
4. ^{^} Those figures showed (www.ons.gov.uk)
5. ^{^} appeared to concede (www.bbc.co.uk)
6. ^{^} stagnated productivity (www.ft.com)
7. ^{^} declining wages (www.ft.com)
8. ^{^} blow to the economy (commonslibrary.parliament.uk)
9. ^{^} driven up inflation (www.ons.gov.uk)
10. ^{^} downward trend (tradingeconomics.com)
11. ^{^} autumn statement last year (theconversation.com)
12. ^{^} inflation has fallen (theconversation.com)
13. ^{^} serious repercussions for the economy (www.researchgate.net)
14. ^{^} just ask the former prime minister Liz Truss (www.theguardian.com)
15. ^{^} Evidence suggests (www.imf.org)
16. ^{^} EPA-EFE/GIAN EHRENZELLER (epaimages.com)
17. ^{^} most important thing (www.researchgate.net)
18. ^{^} low rates (www.ippr.org)
19. ^{^} other G7 countries (www.gov.uk)
20. ^{^} government scheme (www.gov.uk)
21. ^{^} expected until April 2025 (www.gov.uk)