In his budget plans to raise taxes, Chancellor Rishi Sunak revealed a Treasury-led panic to pay off the Covid debt as soon as possible. This was then supported by the Office for Budget Responsibility’s gloomy forecasts for the public finances, warning that rising interest rates could make them even worse.
But this makes no sense. As growth resumes, the debt ratio will come down steadily over time, with some inflation. If one corrects the OBR forecasts to a more balanced trajectory for GDP, such as that of the Bank of England, the improvement in the finances is striking: rising GDP raises tax revenue and lowers benefit payments sharply.
Of course, we do not know how long it will take to bring the debt ratio down to sustainable levels below 60 per cent. However, this does not really matter; the key point for solvency is that the underlying direction should be stable or downwards. After the Napoleonic Wars when the ratio reached 200 per cent, it took almost the whole Victorian century to do so. After World War II when it was around 150 per cent, it took a half century until 2000.
At present, with real interest rates negative and growth strong post-Covid, the condition for solvency is plainly over-satisfied. But of course, real interest rates will rise in the next few years, with inflation threatening, and growth will settle back to its normal rate.
Nevertheless, two things emerge from present trends. The first is that with our flexible labour market, employment is likely to revive sharply with the post-Covid recovery, just as it did after the financial crisis. This is likely to deliver 2 per cent trend growth, which happens to also be the pre-Covid average growth rate in the 30 years to 2019; in that figure, productivity slowed down, while employment growth compensated.
However, there is evidence from around the world suggesting that productivity measurement has been biased downwards by not picking up the effects of new technologies.
The second is the need for the government to support growth with new policies boosting entrepreneurship and innovation. It is already committed to a new pro-growth approach to regulation, which is very welcome. But there is ample evidence that growth also depends on tax rates, particularly marginal tax rates on businesses and their owners. It would be tragic if these were put up just as there is maximum need to get the economy going strongly after the Covid episode, and to make the UK it maximally attractive to post-Brexit investors.
Far from raising taxes soon, this is the right moment for putting forward a bold agenda for cuts in key tax rates and an infrastructure-building programme, especially oriented to the North, which also, according to our regional research, benefits most strongly from the tax-cutting agenda.
In my research team’s latest forecasts, we have projected the public finances on existing policies (minus the ill-considered tax rise plans) and also with this bold fiscal agenda. Under existing policies, the debt ratio comes down to around 50 per cent by the mid-2030s. With the fiscal package, costing £100 billion a year from 2024, growth is boosted by 1 per cent and the debt ratio falls to around 45 per cent; in effect the package pays for itself.
In sum, the large Covid debt is no reason to rush around in panic to pay it off with higher taxes. On the contrary, with the UK’s strong solvency history, we should take our time and let growth bring it down over time, meanwhile doing what is necessary to ensure the strongest possible growth trajectory in the coming decade.