Dynamic inconsistency

The UK is largely governed by Philosophy, Politics and Economics graduates, including both this Prime Minister and his predecessor and the current Chancellor. As successive budgets demonstrate, we can always count on the lessons learned in the politics lectures to be reliably implemented, economics only in extremis (when the money runs out), and philosophy never.

Start with economics. The meltdown that immediately followed the mini-budget demonstrated that as Britain has lurched from crisis to crisis, accumulating yet more debt each time, its creditors have finally reached the limits of their patience. While most blamed the tax cuts, the introduction of the energy price cap was at least as damaging. Raising the price cap will not only save money, but encourage conservation and reduce the chance of shortages. The Chancellor should have gone further.

When it comes to taxing property, the rise in council taxes is another good policy — but it’s a shame that stamp duty will be restored in 2025 to its previous levels rather than phased out completely. The former is an efficient way to raise revenue, whereas the latter generates inefficiencies in both the labour and housing markets by penalising job mobility and discouraging the elderly from downsizing so that young families can purchase those larger houses.

Will the fiscal consolidation be enough to convince financial markets? The deficit will be 7.1% of GDP in 2022-23. Most of the spending cuts in the planned £55 billion fiscal consolidation are deferred till after the next election. This creates a familiar problem in macroeconomics called dynamic inconsistency — policies that are politically unpalatable today are never implemented, because they are just as unpalatable tomorrow.

I was critical of Truss and Kwarteng’s assertions about tax cuts being self-funding. Yet their emphasis on growth, rather than distribution, was not unwarranted. First, we must dispense with the myth that the UK is the fifth richest economy in the world. It is, for now, the fifth largest; but on a per-capita basis, the only comparison that is meaningful, it ranks number 24 on the IMF’s list of 40 developed economies.

In terms of purchasing power parity, the average American enjoys 34.6% more income, and the Dutch and Belgians have a considerable 24.8% and 11.1% more purchasing power respectively. Germans, despite still bearing the enormous costs of reunification and rehabilitation of the decrepit economy of the DDR, enjoy incomes 14.3% higher than those seen in the UK. In 1980, per-capita income in Taiwan was just one third of that in the UK; today it is 24.4% higher.

Low rates of investment, both public and private, on capital as well as research and development explain some of this underperformance. Rises in corporation and business taxes and higher taxes on dividends, along with the increase to 35% in the windfall profit tax, will lower the expected after-tax return on investment and will only prolong this record of stagnation.

As for philosophy, once again this budget fails to address the more fundamental question of what functions should be provisioned by the state, and what is better relegated to civil society, or left to the responsibility of the individual citizen. Yet more money is budgeted for health care, social care, welfare support, rent subsidies, and to protect the triple lock on pensions. This leaves less for the more basic functions of the state — including defence (lowered back to the Nato minimum of 2% of GDP), law enforcement, and courts.

If during peace time, a tax burden of 37.5 per cent of GDP by 2024-25 is consistent with the Tories’ concept of a free liberal society, how much higher will it go, when as we expect they are replaced in two years by Labour?

Professor Michael Ben-Gad is Professor of Economics in City’s Department of Economics. He joined City as a Reader in 2007 and served as Head of Department between 2010 to 2013. His research focuses on Dynamic Macroeconomics with applications to taxation, public debt, the economic effects of immigration, national security as well as the emergence of multiple equilibria in models of economic growth.