Updated: Oct 31, 2022
Former chancellor of the Exchequer, Kwasi Kwarteng, released his mini-budget on Friday the 23rd of September as an emergency response to the turbulent cost-of-living crisis and the currently concerning economic outlook. Although the ‘mini’ component of the phrase derives from its unusual and non-official time of release, its name is rather ironic; the budget outlined the biggest tax cuts seen in 50 years.
The proposal detailed the reduction of the basic income tax rate from 20% to 19%, freezing the previously scheduled 6 percentage point increase in corporation taxation (19% to 25%). Though the most controversial aspect of the budget was the abolishment of the 45p top tax rate, a huge talking point of this drastic supply-side targeted plan[i].
So how did the markets react to Truss’ ‘growth before popularity’ mandate? A drop in confidence for the proposition caused a historic crash in the value of the Sterling, with the value of the pound declining to an all-time low against the USD of $1.035 on the 26th of September in the Asian time zone trading.
Alongside this extreme reaction in the foreign exchange market, the above image illustrates an equally gloomy picture for the UK Government Bonds (or gilts) market. The sharp fall in the price of gilts is reflective of investors’ unease surrounding the intended £45 billion shortfall of tax revenue, and the subsequent rise in yields also entails the increase in risks to investors. IFS estimates projected that UK Government borrowing was heading towards a whopping £100 billion per year if these plans were to have been upheld[ii].
Foundations of the 'growth plan'
Kwarteng’s policies have shown a clear Tory rationale of targeting the supply side of the economy, with the desired outcome of spurred consumption and investment arising due to higher absolute and disposable incomes. Though, in a time of such extreme inflation, these plans even drew criticism from the like of the IMF, warning that employing expansionary policy would only undermine the Bank of England’s tightening of monetary policy. The conflict between the two approaches may only ‘prolong the pain’ of the concerningly strong upward pressure on goods[iii].
Regardless of the intention, the ensuing chaos in the markets seemed to signal agreement amongst investors– the proposal in question was poorly timed, and questionably designed, especially given the current economic climate. This sentiment is evident among economists and supporters of the Tories alike as Truss’ popularity in the polls has fallen by 16%[iv], and donors and members are defecting left and right. Despite multiple U-turns already – Truss really meant what she said about side-lining popularity for economic prosperity.
Conflicts within the proposal
Putting aside any opinions surrounding the policy announcement, one thing is for certain, the benefits from swathes of income tax cuts are undeniably accrued at the top end of the income scale. An individual earning £100 million per year will be better off by £55,220, someone earning £200,000 gains £5,220 per annum, but someone on a salary of £20,000 will only see their income rise by £157 per year[v].
This absolute gain difference is to be expected, even if the tax cuts were proportional. However, when half of the gains from the cuts go to the richest 5% of income earners, and the poorest 50% of society only receive 12% of the gains[vi] - it raises the question, why do politicians tend to shape policy in favour of the most fortunate in society?
The trickle-down dream
As Truss, and any other conservative party globally, would argue – trickle-down economics is the answer to this very question. Used for decades by politicians as a rebuttal for wealth-favouring policy proposals, trickle-down economics gained mainstream attention in the 80s with the introduction of Reaganomics characterised by liberal market approaches to large-scale tax cuts in attempts to promote growth.
Essentially, as the rich gain more wealth through tax cuts and rebates, in theory, they will spend this increased disposable income through consumption or investment, in turn increasing aggregate demand within the economy. Both of these channels cause greater employment and higher wages those that are now supplying more goods or services to the wealthy observe greater incomes, and will increase their own consumption leading to a multiplier effect as a small increase in incomes at the top end of the scale causes a proportionally larger increase in aggregate demand across the economy. The filtering down of these additional funds from the richest classes to the service-providing middle and lower classes is the essence of trickle-down economics.
It is even argued that, in theory, the increases in consumption, investment, and consequent job creation may even offset the initial loss in tax revenue due to tax cuts as the taxable base grows larger. Hence, describing the shape of the Laffer curve. For this to occur, however, the economy would need to be in a state such that tax rates are already above the optimal tax level T*.
Though, it is far more likely that we are actually in a position that is better represented by the shift from T2 to T3, providing a challenge to the Government’s finances illustrated by the movement of total revenue from R2 to R3. There's a pun that quite aptly describes the problem with this theory as a viable reason to reduce taxes on the richest and most wealthy and it goes, ‘I have a joke about trickle-down economics, but I’m afraid 99% of you won’t get it.’
This is the entire issue with trickle-down economics. As with much economic theory, reality strays considerably from its intended outcomes, and this is especially true in this instance. Using OECD data from 18 countries, Hope and Limburg (2020) set out to identify the effects of major tax cuts for the rich on a number of economic indicators. They conclude that tax cuts for the rich have no significant effect on growth rates or unemployment, contrary to what many politicians tend to peddle, if fact such policies only resulted in greater income inequality[i].
Furthermore, an IMF report published in 2015 found that ‘increasing the income share of the poor and the middle class actually increases growth while a rising income share of the top 20 percent results in lower growth—that is, when the rich get richer, benefits do not trickle down.’ More specifically, raising the income share of the bottom 20% by 1% led to a 0.38% increase in growth rates, while increasing the income share of the top 20% by the same amount led to a 0.08% fall in GDP[ii].
Why does it fail in practice?
One of the most significant pitfalls of this theory is the existence of heterogenous marginal propensities to consume, or more simply, the tendency of people to spend extra income differs within income groups. For example, compare a situation with someone earning £150,000 receiving an extra £2,000 per year to an individual with a salary of £24,000. The increase in disposable income represents a greater change in wealth for the relatively poorer individual, and they are more likely to spend this additional income on rent, bills, or other normal goods. On the other hand, someone that is richer has a higher marginal propensity to save, and will simply save the extra income. Consequently, their consumption patterns are unaffected – leaving the funds accumulated within the wealthiest strata of society with no trickle-down effect.
When the wealthy become wealthier, they tend to increase their investment in assets rather than in businesses bringing up another issue with the concept. Thus, rather than firms enjoying higher capital levels translating to higher employment and wages, the rich increase their investment levels within assets. Resultantly, said assets only appreciate in value only benefitting the wealthy that own them. The housing market is a prime example of this, the affluent purchasing and renting properties only contributes to financially excluding the less fortunate from the market, leading to a reduction in aggregate assets for the least wealthy.
The future of zombie politics
On Friday the 14th of October, after not even 6 weeks in office, Kwarteng stepped down as Chancellor ending his chaotic yet short term in Cabinet. The reaction from the public and markets alike will hopefully set a precedent for future emergency policy decisions. Whether that’s fully balancing cuts with funding plans, to allowing the OBR to present a full economic forecast of the planned policy – with the increased prevalence of information with time these policies that do not actually function in reality should slowly cease to exist.
Edited and Reviewed by Tanish Bagga.
References/ Further Reading:
[vii] http://eprints.lse.ac.uk/107919/1/Hope_economic_consequences_of_major_tax_cuts_published.pdf [viii] https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2016/12/31/Causes-and-Consequences-of-Income-Inequality-A-Global-Perspective-42986 [vi] https://uk.news.yahoo.com/who-benefits-from-tax-cuts-liz-truss-kwasi-kwartengs-mini-budget-151737000.html [v] https://uk.news.yahoo.com/who-benefits-from-tax-cuts-liz-truss-kwasi-kwartengs-mini-budget-151737000.html
[iii] https://news.sky.com/story/dont-prolong-the-pain-imf-criticises-uk-government-for-undermining-bank-of-england-12719480 [ii] https://ifs.org.uk/news/weaker-economy-getting-government-finances-sustainable-path-without-cancelling-tax-cuts-could [i] https://www.gov.uk/government/news/chancellor-announces-new-growth-plan-with-biggest-package-of-tax-cuts-in-generations