Opinion: Truss learns what all politicians should know: Tax cuts, grants or debt cancellation aren’t free lunches

0

CAMBRIDGE, Mass. (Project Syndicate)—Following an immediate and brutal reaction from the financial markets, British Prime Minister Liz Truss has fortunately abandoned her government’s proposal to lower the tax rate paid by the country’s highest earners. Nonetheless, the experience that followed his ill-advised “mini-budget” should serve as a wake-up call to policymakers around the world as they pursue measures to help households hit by rising energy prices and inflation more broadly.

While the UK’s financial market drama garnered the most attention, it wasn’t even Truss’ main strategy issue. The most fundamental problem today is that all policies designed to help one group – whether they are tax cuts for the rich, sales tax cuts (in Florida), tax cuts lump sums (in California), student debt relief or energy subsidies – must ultimately come at the expense of other groups.

The lesson of this arithmetic is that you can’t evaluate a policy just by looking at who gets the money. There is another side to the story, and that is who pays – either through higher prices, higher interest rates, higher taxes, future repayments of external debt or reduced benefits.

This economic logic is simple and ruthless. Each time a country reduces taxes or increases benefits for a group, it allows members of that group to increase their consumption. If total production can increase to meet this additional consumption, all will be well: the economy will produce more, the favored group will consume more, and everyone else will be unscathed.

Rob Peter to pay Paul

The problem today is that production will not increase simply by dint of certain groups receiving transfers. In most advanced economies, unemployment is about as low as it has been in decades, capacity is fully utilized and central banks are doing all they can to reduce demand. If one group is entitled to spend more, the others will have to spend less.

This dynamic reflects four factors. The first is inflation. When a government cancels student loans or subsidizes energy, it increases the purchasing power of affected groups and thus contributes to inflation. Direct beneficiaries can buy more, but everyone else can afford less. And if government largesse causes the currency GBPUSD,
-0.82%
weaken – as has happened in the UK – which will also force people to pay more, in this case for imported goods.

The second factor is rising interest rates. A government that increases spending or reduces taxes must borrow more, and this borrowing will increase competition for scarce savings. As a result, savers may demand higher returns and borrowing costs – the interest rate – will rise accordingly. Moreover, to the extent that central banks try to rein in the associated inflation, they may deliberately raise interest rates even further.

In the case of the United Kingdom, the increase in interest rates occurred at the very moment when the mini-budget (with its significant tax and social advantages) was announced.

Higher interest rates mean higher mortgage payments, higher car loan repayments and other costs, which will force households that did not receive the transfers to cut spending. In the UK, where most households have variable rate mortgages, millions of homeowners will soon be paying more each month, even under the reduced mini-budget.

The loan must be repaid

The third component is the increase in foreign borrowing. When a country’s production is at full capacity, its total consumption can still increase through imports, but these must be financed by foreign borrowing, which is already very high in the US and extremely high in the UK. . Because these foreign loans must ultimately be repaid. , policies that increase it effectively help people in the present at the expense of people in the future.

The final ingredient is fiscal austerity. Tax cuts or benefit increases today must inevitably be reversed in the future. Although the government does not need to balance its budget every year, it must ensure that its debt does not explode over time. All the tax advantages it offers today must eventually be combined with equal and opposite reductions in the future.

Sometimes that future is far away; but sometimes it’s closer than people think. The UK, for example, is already considering waiving or reducing cost-of-living adjustments for government benefits, due to concerns over its growing deficits and external debt.

The lesson of this arithmetic is that you can’t evaluate a policy just by looking at who gets the money. There is another side to the story, and that is who pays – either through higher prices, higher interest rates, higher taxes, future repayments of external debt or reduced benefits.

In the case of Truss’ original plan, the bottom 95% of Britons were to pay for tax cuts benefiting the top 1%. But even in the least extreme cases, knowing who is paying can give policymakers invaluable perspective. Often a superficially appealing attempt to help a group won’t seem so appealing once you consider how it affects others.

The government is not powerless

This does not mean that the government is powerless to help people in times of need. Many of these indirect costs can be avoided if increased government spending or tax cuts also lead to increased output, as can happen with fiscal stimulus in a depressed economy or with very well-designed investments. . Moreover, providing targeted assistance to the most vulnerable may incur indirect costs for others, but if this burden is distributed and sufficiently reduced, the benefit will be worth it.

And sometimes, in the face of a temporary shock like skyrocketing electricity costs in Europe following Russia’s invasion of Ukraine, it makes sense to help the people who are suffering today at the expense of the people of tomorrow.

But in all these cases, it is essential to exercise caution. Policymakers can do themselves a favor by making sure they don’t rush to help certain groups without giving equal weight and consideration to all who will end up paying the price. Truss just learned that lesson the hard way.

Jason Furman, former Chairman of President Barack Obama’s Council of Economic Advisers, is Professor of Economic Policy Practice at Harvard University’s John F. Kennedy School of Government and Senior Fellow at the Peterson Institute for International Economics.

This comment was posted with permission from Project Syndicate — The Trusonomics Warning

Learn more about fiscal policy

The pound rises and bond yields fall after the British government scraps its plan to cut taxes for the wealthiest earners

Ex-Bank of England chief says new government undermined other institutions

New Truss government is like a doomsday cult, says UBS economist

Share.

Comments are closed.