A series of unfortunate fiscal events

Economics means more direct fiscal support for paying bills is needed. Politics has put wider tax cuts on the table.

In less than a week, barring a major upset, Liz Truss will be Prime Minister. In less than a month we’ll get an ‘emergency budget’ with a major fiscal expansion.

But what will that look like?

The smoke signals from the Truss camp could be charitably described as ‘confused’. There have been weekends where ‘further handouts’ have been ruled out on a Saturday morning only to be ruled back in by Sunday afternoon.

For what it’s worth, the plan trailed in the Times this weekend – cutting VAT, raising the income tax personal allowance and possibly either cutting the basic rate of income tax and/or raising the higher rate threshold – is just about the worst macro-policy response to the current energy-driven supply shock I can imagine. It would manage to combine being very expensive with being extremely poorly targeted. The households and firms most exposed to rising energy bills would see little direct support. It is also the kind of fiscal action almost certain to draw an immediate monetary policy response.

Stepping back, it is worth thinking through both the politics and the economics of the situation to get a sense of what sort of package to expect by late September.

The economics here leads the politics. As I wrote last week, household energy bills look set to reach the kind of levels that imply both widespread destitution and a collapse in discretionary spending that will hit firms extremely hard. No government can realistically let this happen. So there will be some sort of ‘handout’ or bill capping.  That is going to be pricey for the Treasury.

But the politics of this leadership race mean tax cuts are unavoidable. Indeed many of the policy suggestions being thrown around by Truss allies over the past few weeks are best read as an attempt to find a tax cut that will help in the current crisis.

The problem they are finding is that direct tax cuts on energy (cutting VAT on domestic fuel to zero or dropping green levies) are too small to make a difference whilst the broader tax cuts being floated (VAT, income tax, etc) do not address the actual problem.

So where does that leave policy? It leaves us with ‘handouts’ and tax cuts. At the very least Truss will have to cancel the rise in National Insurance Contributions introduced by Rishi Sunak and unwind some of the planned rises in corporation tax. Anything else will be greeted as an immediate betrayal by her backers.

I suspect the wider talk of immediate cuts in VAT or income tax will be pushed back but I can’t rule out a combination of more direct support for households & firms, cuts in NICS and corporation tax and further cuts in personal taxation.

The real difference between Rishi Sunak and Liz Truss when it comes to economics is to be found in their views on deficits. Both are by instinct smaller state, lower tax, deregulators. But whilst Sunak is a fiscal conservative first, Truss is not. The limits of this approach will be tested in the months ahead.

Things will only get more expensive this Autumn. After signing off a package of support to households and firms this September, the next item in the new Chancellor’s in-tray will be deciding how much to protect departmental funding from rising inflation. The idea that the NHS and schools, at the very least, will not be provided with some extra funding (even if not the full inflation adjustment) is politically inconceivable.

As I noted (I think reasonably early!) next month’s fiscal intervention will not be an official ‘fiscal event’ accompanied by a new set of OBR forecasts.

On one level, that is fair enough. It is better to give the OBR the time and space to compose new forecasts than to make-do with a rush job. Equally, in an energy price and economic emergency the government must act quickly. It would have been ridiculous to wait for weeks and new forecasts before introducing the furlough scheme in the Spring 2020. It would be equally ridiculous to wait until November or December to act on energy prices now¹.

But there is a difference between providing emergency support without the full fiscal picture and making longer term changes in the tax system without one. In an ideal world the new government would hold back on NICS, corporation and other tax rate changes until the Autumn. But I cannot see the new government waiting for the OBR to mark its homework before pressing go on tax cuts.

All of which sets up a rather unfortunate series of fiscal events over the coming months.

Next month will see an energy price package worth perhaps something like 1/1.5% of GDP at the lower end to 4% or so if they go big. Alongside that will come discretionary tax cuts worth perhaps about 1% to 2% depending on where they settle. We are talking in terms of big numbers – with big defined here as macroeconomically significant.

That will be followed up with a budget eight to twelve weeks later which see yet more spending on public services and a new set of OBR projections showing the impact of a weaker than expected back in March economy, much higher than expected inflation, Sunak’s May cost of living package and whatever the Truss government has announced since. The fiscal rules will no doubt have to be changed again to justify all of this.  John Redwood, reportedly soon to be a Treasury minister, has already hinted as much. Oh, and if you think the government is going to raise fuel duty on petrol by 5p next Spring (to unwind Sunak’s ‘temporary’ cut) then I have a bridge to sell you.

The risk is that this all starts to look like a complete breakdown in fiscal discipline. One which pushes the Bank into even faster hikes.

The sad irony is that the case for looser fiscal policy – and indeed looser macro-policy in general – has been strong for much of the last decade. Britain seems set to finally get a government more relaxed about deficits just as the economic environment shifts.

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1. Indeed it is already somewhat ridiculous that Britain’s lack of a functioning government has meant we do not have a package in place already.