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Sunak returns to the 1960s

Rishi Sunak's Budget means economic policy has returned to that of the 1960s
March 3, 2021
  • Chancellor's statement evokes economic policy orthodoxies of the 1960s
  • Hikes mean the share of taxes in GDP will rise to 35 per cent by 2025

Chancellor Rishi Sunak used this week’s Budget to announce a return to the economic policy orthodoxies of the 1960s.

One way in which he did so is by embracing counter-cyclical fiscal policy. He announced a fiscal loosening of £58.9bn (2.6 per cent of GDP) for the financial year 2021-22. Much of this, as expected, is due to the extension of the furlough scheme, support for the self-employed and cuts in business rates. But it also comprises a huge unexpected measure – so called “super deductions” for capital spending, under which firms will be able to cut their tax bill by 25p for every £1 they invest. This means that for the next two years the Treasury will pay firms to invest. In this sense, Sunak has heeded Maynard Keynes’ famous 1936 call for a “somewhat comprehensive socialisation of investment”.

Thanks to this tax break, the OBR foresees a short-lived boom in capital spending, expecting business investment to soar by 16.6 per cent next year, more than making up for its fall in 2020.

The danger, though, is that such spending is not just in profitable projects but in schemes undertaken merely to attract government money. In fact, the OBR foresees investment falling back as the tax break ends in 2023. Nor does it envisage this spending raising productivity growth much. It foresees output per worker-hour growing by only 1.3 per cent a year between 2021 and 2025. That’s much less than the pre-2007 trend – and, as economists have pointed out, the OBR has consistently been over-optimistic about productivity growth.

Sunak, however, also announced plans to claw back this year’s giveaways, with a fiscal tightening of £54.7bn pencilled in for 2024-26, equivalent to over 1 per cent of GDP. Although the freezing of income and inheritance tax allowances are part of this tightening, the biggest burden falls upon companies; the rise in corporation tax from 19 to 25 per cent is expected to bring in over £45bn between 2023 and 2026. The OBR warns that this will depress longer-term growth. It will, it says, “increase the cost of capital, lowering the desired capital stock and business investment in the medium term”.

These tax rises mean the end of (relatively) small government. The OBR says the share of taxes in GDP will rise to 35 per cent by 2025, its highest ratio since the late 1960s.

Partly because of this – but also because of the underlying forces for stagnation in western economies – the OBR foresees economic growth falling back as the post-pandemic unleashing of pent-up demand recedes. It expects real GDP growth of 4 per cent this year and 7.3 per cent in 2022, but an expansion of less than 2 per cent a year thereafter – growth rates that were considered disappointing before the 2008 financial crisis. And the OBR foresees unemployment remaining above its pre-pandemic level until at least 2026.

Nevertheless, government borrowing is expected to fall. The OBR foresees net borrowing dropping from £354.6bn this year to £85.3bn in 2023-24, with smaller falls thereafter. This is less the result of fiscal policy and more the result of private sector decisions. Government borrowing, by definition, is the counterpart to private sector net saving. The latter hit record highs last year as lockdowns prevented households from spending and caused firms to put investment plans on ice. This year and next, however, these savings will fall back to more normal levels – albeit helped in part by government encouragement in the form of those investment super-deductions. As this happens, government borrowing will fall simply as it is the mirror image of private savings.

Although borrowing will remain high, it might not be so high as to raise government debt relative to GDP. This is because as long as real interest rates remain negative, debt will fall in real terms even if a moderate deficit remains. This reliance on low real interest rates to hold down debt is another way in which Sunak is returning to the 1960s.

The similarities don’t end there. Sunak’s “economic plan for significant investment in skills, infrastructure and innovation” echoes the 1965 “National Plan” of the Labour government, which promised to invest more in industrial training and technology and “put new zip into British industry”. That plan, of course, failed to significantly raise medium-term growth.

We might hope that, in this respect, the parallels with the 1960s break down. Such a hope might, though, be a forlorn one. As Dietz Vollrath, John Landon-Lane and Peter Robertson have pointed out, it is actually very hard for governments in developed economies to raise trend economic growth.