Rishi Sunak - More Milton than Keynes?

Rishi Sunak has had a good crisis. His decisive, generally sure-footed, actions and his natural energy stand as cruel comparison to his second-rate Government colleagues.

The furlough scheme has doubtless been abused, or at least used creatively, by many firms but as a mechanism for getting more cash into (and throughout) the system quickly it was remarkably successful. A fair criticism of Governments of all hues is that they are good at making spending promises but very slow at delivering on those promises. Hindsight is the enemy of quick and dirty solutions and doubtless many, many months of committee time will be spent picking over the bones but the fact remains the furlough scheme did what was needed to be done at the time.

While this and other elements of the fiscal stimulus may have been effective, they leave Mr Sunak with a £400bn hole to fill. There is little rush to do so; servicing the debt, especially if the economy is growing, is well within our means. Very low interest rates mean that despite borrowing 19% of GDP our debt interest will be around £13bn less than last year. (Source: The Economist). Fortunately, the Chancellor seems prepared to bide his time until the extent of the damage caused by the Covid crisis (and, in all probability, Brexit) become clearer.

Last week Mr Sunak revealed his spending plans but we’ll need to wait until the Spring to see what he has in mind for balancing the fiscal equation; how much of this spending will be paid for by taxes, how much by borrowing, which, in the post-Covid zeitgeist where we are all Keynesians, means printing more money. Without falling into the trap of trying to predict the future, I thought it would be interesting to look at some of the economic constraints facing Mr Sunak and how he may square these with his political constraints, both self-imposed and external. I think it is pretty certain the general level of taxation will rise; the questions are when, how and by how much.

To understand ‘when’ we need to go back to our economics textbooks and consider the implications of, and limits to, the extraordinary fiscal stimulus we have seen deployed globally in response to the crisis. This was discussed at length in three of our videos earlier in the year but, at the risk of a misleading over-simplification, the stimulus can continue until there are signs of inflation caused by too much money chasing too few goods and services. In recent years, central banks have used ‘forward guidance’ to help manage interest rate expectations and aid monetary stimuli. A similar process is being used in Australia for fiscal policy – there they have pledged not to tighten fiscal policy until unemployment crosses a 6% threshold. Unfortunately, we do not yet have a similar signaling mechanism in the UK.

Managing monetary policy would be easy if it was the only driver of inflation. The economy has two levers, fiscal policy and monetary policy, and one spanner, political intervention. Unfortunately, an inflationary political spanner in the form of Brexit is about to be thrown into the machinery of the economy. Disentangling the causes of any inflation between Brexit, excessive monetary easing or a genuine recovery will be challenging.

Inflation expectations lead to inflation. Workers, concerned inflation is around the corner, seek higher pay awards. Manufacturers fretting their input costs will rise, increase their prices in anticipation. If Mr Sunak is to have the flexibility to use monetary finance to its full extent to support the recovery he needs to keep a lid on inflation expectations. Last week’s announcement of a freeze on public sector salaries was precisely that – he has dampened the inflationary expectations of nearly half the working population and sent a clear signal to the rest. The purpose of the cut in our overseas aid budget is less easy to justify and seems shortsighted when one considers where future global growth will come from.

The high levels of monetary financing mean that central banks rather than markets are setting bond and, by extension, real interest rates. The banks’ priority is economic recovery so it is likely they will, though extended bond-buying, keep interest rates at very low levels until the recovery is well-established. While the Treasury and the BoE are spending so much time and effort pumping money into the economy it makes no sense to raise the general level of taxation – indeed, there is a stronger argument for tax cuts. So, I do not expect an immediate increase in general taxation.

However, while there is no immediate financial imperative to raise revenue there are other considerations. Tax is principally used for two purposes – financial (to raise revenue and to manage monetary policy) and as a spur for behavioural change. There is some behavioural change that would arguably benefit the recovery. For example, limited companies are used widely as a tax-shelter with profits taxed at lower corporation tax rates rather than income tax rates. It is likely there will be a change to the way surplus cash and investments are taxed with an emphasis on companies being used effectively as a means of diverting salary. There has been discussion around taxing surplus cash in companies as income to the shareholders. This is an attractive option for Mr Sunak. He can fairly claim that surplus cash would be better invested in growing the company, or even simply given to shareholders to spend, rather than locked in a shelter against income tax.

This would prove particularly unhelpful for those entrepreneurs who are building cash in their companies to fund their retirement. Following the publication of the review of Capital Gains Tax it has been widely assumed the differential between taxation of income and capital will be reduced. It was only 12 years ago that you paid CGT at your marginal income tax rate so it wouldn’t be a great leap to go back to those times. It makes sense – it is unfair to pay less tax simply by holding an asset than you do by working hard and this is doubly so when the value of that asset is being supported by Government policy. However, it is unlikely that it will become less advantageous to make capital gains rather than income.

To understand when Mr Sunak will start to tighten the tax screw more widely it’s perhaps worth looking more closely at the man who seems to have appeared from nowhere to save the nation, a beacon of competence in an otherwise depressingly uninspiring cabinet too obviously selected for their loyalty to the Brexit experiment rather than ability. Mr Sunak may have married into a fabulously wealthy family but his own relatively humble beginnings have strong parallels with the progenitor of his Thatcherite views, down to helping in the family shop and understanding the value of hard work – both of which, one suspects, would be anathema to his boss.

His enthusiastic support of Brexit and commitment (indeed ‘sacred duty’) to leave the country’s finances strong and to balance the books suggest his core beliefs are closer to Mrs T’s preferred economist, Milton Friedman. A passionate advocate of free trade, Friedman provided the intellectual economic ballast that gave Mrs Thatcher the confidence to tackle the stagflation that was crippling the economy in the late seventies. Contrary to Keynes, Friedman believed increasing money supply would, in the long run, simply result in inflation with no impact on output – which doesn’t auger well, until one considers the experience of Japan over the last two decades and the rest of the developed world since the financial crisis. In both cases monetary expansion has not resulted in inflation.

For now, Mr Sunak can stay firmly on the fence, but, when the time comes, it will be interesting to see whether his spirit leans more towards Milton Friedman or Keynes.

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