Cutting taxes means cutting public services or damaging fiscal sustainability 

The Conservative leadership contests has, so far, become a battle of who can promise to cut more taxes. Whoever wins, their next chancellor will be under intense pressure, from Conservative backbenchers and possibly the new occupant of Number 10, to cut further and faster. At the same time, Treasury officials will be warning of the risks of such a move. The new chancellor would be wiser to listen to the officials.  

Without raising taxes or reducing spending, government finances will head into explosive territory 

Recent tensions between No.10 and No.11 over whether to cut taxes were referenced by Rishi Sunak in his resignation letter. But the warnings about the impact of tax cuts are stark, with a new report by the Office for Budget Responsibility (OBR), the government’s official forecaster, warning that the public finances are on an unsustainable path. Richard Hughes, chair of the OBR, said at a recent IfG event that the first question to any leadership candidate calling for tax cuts should be whether they are going to pay for tax cuts by reversing increases in spending (for example recent increases in the DHSC budget) or increase borrowing. 

This is primarily due to increases in spending on health and social care – a consequence of an ageing population as well as increasing costs in the health sector. The second most important factor is state pensions spending, which is projected to increase significantly, also as a result of the UK’s ageing population and the current ‘triple lock’ policy.

With ambitious policies levelling up and net zero requiring a significant amount of additional public spending, and the scope for further ‘efficiency’ savings very limited given the past decade of cuts, it is easy to see why most recent chancellors have opted to raise the tax burden to historic highs to balance the books. This is too often read as being a contradiction of Conservative principles or as an expansion of the state, when it is instead a reflection of the fact that providing basic public services such as pensions and health and social care is becoming more expensive. Public spending (and taxation) would rise even if there was no expansion of the functions of the state, and similarly keeping borrowing and taxation flat would necessarily correspond to a real reduction in the provision of public services (per capita). 

Temporary broad-based tax cuts would fuel inflation 

The new chancellor may think that a temporary tax cut would be a good option to help ease the cost of living crisis, and mean limited long-term fiscal implications. As we have recently argued, that would also be an unwise move. Such broad-based measures would be expensive and make the inflation problem worse while being unlikely to provide a significant boost to demand. They would also be unlikely to help with the cost of living, since the Bank of England would react by raising interest rates to counter the inflationary impact of the policy. Such policies are also difficult to reverse and risk becoming permanent – even more so if the incumbent government is weak, nearing an election, or both.  

The argument that tax cuts will pay for themselves by stimulating growth is nonsense 

Some proponents of tax cuts – particularly to corporation tax – argue that they can pay for themselves by stimulating more investment and growth. This is not a view shared by the OBR: when Rishi Sunak announced plans to increase the rate of corporation tax by six percentage points to 25%, the OBR acknowledged there would be a modest negative impact on investment, but that the change would nonetheless bring in an additional £17bn of revenue by 2025/26. ^[1] Richard Hughes, the chair of the OBR, also noted at the Institute for Government event that in the long run there is no relationship between the tax burden and growth, with supply side factors such as the labour force, skills and capital playing a much greater role.  

The argument that tax cuts can generate revenue is not supported by much evidence. The only cause for concern might be if the UK’s tax rates were much higher than in other countries (leading businesses and people to relocate) but, even with the latest six percentage point increase, the UK remains middle of the pack of advanced economies when it comes to the effective rate of tax on company profits.   

The evidence, should the new chancellor act on it, will lead them to dismiss calls from No.10 and backbenchers for broad-based cuts in taxes. Such a move would undermine fiscal sustainability, public services, or both in the long-run. It would also be inflationary in the short-run. 

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1. https://obr.uk//docs/CCS207_CCS0221988872-001_CP-387-OBR-EFO-Web-Accessible.pdf