Tax cuts and borrowing – does it make sense?

Can a funded tax cut help create jobs and activity? Does a tax cut have to be unfunded to work its magic of reflating an economy?

This is the new idiocy in Labour’s view of the economic debate. To them an unfunded tax cut – a tax cut which means the state has to borrow more on behalf of taxpayers to carry on with its high spending – is the only type of tax cut which makes sense as they try to stop recession turning into depression. This, like all government soundbites, needs examining.

A tax cut “paid for “ by borrowing does not necessarily reflate an economy. It depends who lends the money to the government, and what else they would otherwise have done with it, it depends on how the government spends the money it borrows, and how the person or company receiving the tax cut behaves.

If the money the government needs is all borrowed from UK individuals and companies, they will spend less on goods and services in the UK in order to find the money to lend to the government. Mr and Mrs Prudent may be tempted to save more and spend less if the government offers attractive interest rates in order to borrow all the extra it needs.

If the people receiving the benefit of the tax cut use it partly to repay debt or to save themselves, that portion of the tax cut will not be spent and will not generate immediate employment for others. Mr and Mrs Overstretch will not reflate by spending if their nationalised mortgage company is demanding more interest and their semi nationalised bank is demanding repayments on the credit card account. If higher income people spend their tax cut on imports or a foreign holiday, the favourable impact on UK jobs of the spending will be also be much diluted.

If the government persists in spending much more than it collects in taxes, not all of this spending creates extra jobs or activity. Some of it passes to public employees who save it. Some is put into public sector pension funds who may keep it in cash or invest it abroad.

Conversely, a tax cut “funded” or paid for by reducing government spending may still be reflationary to some extent. Again it depends on who receives the tax cut, what they do with the extra money, and where the public spending saving comes from. Let us take a desirable but unlikely example. Let us assume that the government decided that every public employee earning more than say £63,000 a year (an MP’s salary) was to take a pay cut to help sort out the crisis. Let us suppose this was spent on giving income tax cuts to the lower paid. A substantial chunk of income would pass from people who are saving a considerable proportion of their good incomes, to people who would spend more of it as their budgets are badly squeezed. It would probably also help the balance of payments, as people on high pay tend to spend much more on foreign travel and other foreign luxuries. This would have some reflationary benefits. A more realistic example might be some reduction in government payments to very expensive consultants, who save or spend abroad substantial amounts of their income, to allow a tax cut to lower paid people who will spend more of it.

The point the government does not want to understand, but the MPC now does, is the risk of borrowing too much. If a country borrows more than investors in international markets think is reasonable, the whole country ends up suffering. The currency falls, making all imports dearer, and the price of borrowing rises, making all taxpayers worse off. In extreme cases like Iceland there can be a collapse of normal banking and commercial activity and the need to go to the IMF and other foreign lenders for the imposition of proper public spending and borrowing disciplines – something a Labour government had to do in the UK in the 1976. That is why the Opposition is right to urge the government to keep its borrowing within sensible limits for these extraordinary times.

I favour tax cuts as always, but I also favour better controls on public spending, starting with the over expensive banking share buying. “Back the banks, don’t own them” should be the slogan..

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14 Comments

  1. Stuart Fairney
    Posted November 20, 2008 at 9:30 am | Permalink

    JR recommending other blogs on yours seems a little rude, but if I may, this video neatly and with some real humour seems to me to sum up the government policy on bailouts
    http://www.adamsmith.org/blog/misc/and-another-th

  2. Brian Tomkinson
    Posted November 20, 2008 at 11:15 am | Permalink

    The 1976 IMF intervention should be used repeatedly to illustrate the logical conclusion of Brown's manic borrowing plans. Labour continually refer back to previous Conservative governments, often in a most spurious way, but in this case the consequences of profligate borrowing are clear for all to see and should be brought vividly to the public's attention.

  3. oldtimer
    Posted November 20, 2008 at 12:10 pm | Permalink

    It will be interesting to see if Brown and co volunteer a 10% cut in their pay and benefits, as part of next Monday`s measures – as the Irish cabinet has done recently. This would be a literal and manifest example of "feeling the pain". Perhaps the Conservatives should adopt this idea and present it themselves. Hair shirts are the order of the day.

  4. Neil Craig
    Posted November 20, 2008 at 1:30 pm | Permalink

    One point in favour of putting all this proposed £30 bn tax cut into corporation tax, which would get us down to the rates that have given Ireland 7% growth, is that if Laffer is right business expansion would mean that CT payments would, over a few years, increase to more than the original figure. Every other tax cut paid by borrowing has to be temporary, until the recession is over (or more cynically until the election is over).

    I'll admit I suspect Arthur Laffer is slightly optimistic & that there would still be some medium term cost but that since this would greatly improve the economy as whole it would be well worth doing.

  5. Nick
    Posted November 20, 2008 at 1:40 pm | Permalink

    .

    Conversely, a tax cut “funded” or paid for by reducing government spending may still be reflationary to some extent. Again it depends on who receives the tax cut, what they do with the extra money, and where the public spending saving comes from. Let us take a desirable but unlikely example. Let us assume that the government decided that every public employee earning more than say £63,000 a year (an MP’s salary) was to take a pay cut to help sort out the crisis. Let us suppose this was spent on giving income tax cuts to the lower paid. A substantial chunk of income would pass from people who are saving a considerable proportion of their good incomes, to people who would spend more of it as their budgets are badly squeezed. It would probably also help the balance of payments, as people on high pay tend to spend much more on foreign travel and other foreign luxuries. This would have some reflationary benefits. A more realistic example might be some reduction in government payments to very expensive consultants, who save or spend abroad substantial amounts of their income, to allow a tax cut to lower paid people who will spend more of it.

    Clearly, if the public is a better spending of their money, then cutting public spending and replacing it with taxes results in an improvement of spending. It's spent wiser.

    However, its inflationary as you say, if people spend and don't save.

    That's a bit short term, isn't it? You're just delaying the pain until we have to start paying off that huge pensions liability that all parties have a problem talking about

  6. Tim
    Posted November 20, 2008 at 2:54 pm | Permalink

    Good summary John.

    I've been getting inceasiingly annoyed by Labour's borrow to throw cash around approach which is simply deferred taxation a year or two hence.

    I was shocked reading HANSARD for Monday and the puerile way our Prime Minister conducts this debate.

    I always come to your website to get robust but courteous opinions on what's going on.

  7. adam
    Posted November 20, 2008 at 3:39 pm | Permalink

    Funny to see the clueless Scot defend himself by referencing the IMF.

    They are all liars and frauds. The only genuine socialist is Tony Benn.

    His prediction that Osborne would damage the pound? Yet another failed prediction from Crash Gordon.

  8. mikestallard
    Posted November 20, 2008 at 7:27 pm | Permalink

    I play a lot of "Railroad Tycoon". At the moment, I am building a railway through East Africa, but there is insufficient capital: I am broke.
    I can borrow half a million at 13%. If I do, I shall stop making any profit, and the railway will gradually lose money, as any further hope of recovery will slowly disappear. (Borrowing us out of debt).
    I can sell stock, which I do regularly! It brings in a pittance because my credit rating is CCC. (Printing more money, bonds etc).
    I can hope for an unexpected handout from, in this case, a Masai chief whom I have befriended. He is good for about £300,000 – once only. (Why has Mr Brown been on a world whip round, I wonder?)
    Or I can make sure the railway runs as smoothly as possible without any glitches at all. (The one thing this government flatly refuses to do or even recognise as a possibility).

    Last night, I completed the junction of the railway between Dodoma in the South and Juba in the North. How did I work this miracle? I made sure the railway ran efficiently and without any wastage at all.

    Please will someone explain why running the economy of GB ltd is any different?

  9. Blank Xavier
    Posted November 20, 2008 at 9:46 pm | Permalink

    Tax cuts are the ONLY actually reflationary measure.

    Any money the Government spends is taken from the economy via taxation. All the Government is actually doing by spending is *redistribution* – and it's not cost free, for firstly, Government taking tax and deciding where to spend it costs money and secondly, Government will spend that money *badly*.

    The only way to actually have more money in the economy is to remove less in the first place – to tax less – and by this I do not mean taxing less by borrowing, because this simply defers removing the money from the economy and you have to remove more, because you're paying interest.

    The problem is Government does not – cannot – reduce spending. Even in a crisis. This is the reason they are looking at borrowing and indeed looking towards Government spending as the "solution" to the problem. It is only a reflection of their financial alcoholism.

    On a historical note, the French Revolution was instigated because the French State had borrowed and spent to the extent that 49.5% of tax revenue was expended *just on paying interest*. The crisis was reached, the State met with Estates-General (representatives of the rest of France, well, the bits which weren't poor :-), nothing was actually achieved – *even in the face of catastrophe* – and shortly afterwards the Revolution occurred.

    My point basically is that Governments *cannot* control spending money – they just can't, it's like cat can't not pounce on a mouse – which means taxes don't go down and that ultimately screws the economy.

    The amount of capital in the economy directly dictates the amount of employment. Basic rule, known since 1776. The more you tax, the fewer jobs there are. The problem with Government is that it taxes and spends that money in ways which don't cause employment – it doesn't invest, it just *spends*. We are taxed to the hilt – to the point where the economy is just barely able to keep growing. If we were taxed less, things would be much better.

    Ask yourself – what would you life be like, if there was no VAT? and everything you bought was 17.5% cheaper. What about no petrol tax? I don't drive, so it doesn't affect me, but I think you'd be paying 80p or so a litre less, isn't it? how much would that be worth each month? what would you do with that money? what if your employer didn't have to pay a couple of hundred pounds each month in national insurance to hire you? how many more staff would they have?

    • mikestallard
      Posted November 21, 2008 at 6:34 pm | Permalink

      Yes, but what if the government axed all its non-jobs? What if it axed the dole or incapacity benefits?
      I do not think, myself, that that would win you the next election.
      But you are so right! Meanwhile, the non-jobs and the dole grow as rapidly as the national debt and the decline of manufacturing.
      Iceland here we come??

  10. THE ESSEX BOYS
    Posted November 21, 2008 at 3:48 am | Permalink

    Absolutely no idea how we'd get there as this sort of smacks of the bad old 60's and Prices & Incomes policy…but, socially, what we need is a standard wage increase for 2 years, ie the same quantum sum per worker irrespective of current wage level.

    This would:

    (a) Ensure that wage inflation and therefore overall inflation does not return.

    (b) Introduce fairness and a sense that we're all in the same boat

    (c) Give the 'biggest' relative rises to the least well off who either NEED them most or are, we're told, likely to spend it to support the economy.

    (d) Mean the 'fatter the cat' the slimmer the relative pay rise and a temporary halt at least to obscene bonuses.

    If the average UK full time pay packet is approx £24,000 pa and 2% would give a tough but acceptable level of wage inflation whilst there's near-zero price inflation, the pay rise for all who work 35 hours per week or more will be £40 per month.
    For those who work fewer hours/part time the rise is pro-rata at say 30p per hour. (That's approx 6% for those on minimum wage)

    Ok, the idea came up in the pub today after our weekly political meeting but is it SO crazy?

    • Max
      Posted November 22, 2008 at 6:30 pm | Permalink

      Essex Boys
      Err … let me think. I'm afraid it is not only a bad idea, but it has been tried before and has failed every time. Think about the historic attempts of governments to intervene in the economy by nationalising an ailing industry, which, when all is said and done, is about trying to keep workers on a payroll who would otherwise lose their jobs (British Leyland, the shipbuilding industy, coal mines etc etc). The ability of a company to keep workers on the payroll and to increase their pay comes from one thing only – a company's ability to make a profit from which to do this. Ordering it done is just wishful thinking that utterly fails (ask Stalin, Mao etc.). So, for that matter, is throwing large amounts of taxpayers' money at the problem.

      Think through the logic of this. You run a small company. If you are not going to make a profit this year, and I order you to pay staff a fixed pay increase, where does the money come from? How do you enforce this? Worse still, to make your suggestion work presumably you must ban redundancies (otherwise I'll just let 5% of the workforce go simply to pay the others). How do you tell a multinational company they can't sack anyone for 2 years and, indeed, will have to pay them more each year regardless of whether you make any profits? Goodbye pretty much every foreign owned employer who will rapidly put their uk operations into liquidation in favour of a country that does not have this policy.

      The way out of this (or at least to lessen the coming strom) is, as JR has consistently said, for the government to tax and spend less. One day (I am not holding my breath) we may actually see a government that understands this. The other element is for the UK to start making things that other countiries want to buy. JR excepted, the party of which he is member certainly doesn't "get it", having committed up to last week's U-turn to spend more (borrowed) money over the next two years than GB's unprecedent spluge in this financial year.

  11. adam
    Posted November 21, 2008 at 5:08 pm | Permalink

    The economy is one of your steam trains leaving a station. Gordon is in control but there is a problem, there is a gradient and it is raining, the wheels are slipping on the rails in these tough environmental times. We are moving forward but not much, some people say we may even start going backward soon despite the vast amount of coal being pumped into the engine.
    What we need is some ingenuity, some applied intelligence, the simplistic full steam ahead is slow and wasteful.
    Pull the right lever and release sand onto the track, improving the grip at minimal cost.

    Gordon needs to be inventive about improving things, a child could throw money at it. What ideas has this great chancellor come up with? None.
    His only one, a ban on short selling, had no effect.

    He is being tested and found wanting, despite the upcoming pre budget, where ideas are promised, it has been over a year now with no effective action.

  12. Tony Pearce
    Posted November 25, 2008 at 11:54 am | Permalink

    Can anybody tell me who the government is borrowing all this money from? This simple piece of information seems to be missing from all the reports I have read on the subject.

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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