Last week, on the back of its World Economic Outlook update, the International Monetary Fund (IMF) warned the UK government against pushing ahead with further tax cuts.[1] As the Centre for Progressive Policy (CPP) noted in its report Funding Fair Growth, and as has now been stressed by the IMF, maintaining public service provision implies higher spending than the Office for Budget Responsibility (OBR) are currently projecting. This situation clearly requires more taxes, not less. However, the government seems to be driven by the standard story that reducing taxes will raise saving, investment and productivity, which would in turn lead to higher growth. Is this the right way to inject economic dynamism in this time of huge fiscal pressures? Or are there other important pieces of the puzzle that we are missing?

Traditional economic theory has long suggested that reducing taxes has the potential to enhance economic growth. The rationale is straightforward: tax cuts provide individuals with more disposable income, leading to higher consumption, while lower taxes on firms provide them a greater incentive to invest. Both these factors hold the potential to stimulate economic growth. If this were always accurate, however, countries with lower taxes should have higher growth rates. But, this isn't always the case. Countries like France, Germany, and Canada, despite having higher taxes than the UK, also enjoy increased productivity, faster economic growth, and less inequality. What are we missing then?

Methodologically, it is hard to determine whether lower taxes have a causal effect on economic growth or not, and if yes, to what extent. Some tax changes occur as a response to economic growth, and analysing a tax cut at a specific point in time may incorrectly suggest that tax cuts hinder growth, especially as they are often implemented during economic downturns. Moreover, failing to account for other factors influencing economic growth, such as government spending and monetary policy, could either underestimate or overstate the impact of taxes on growth. Certain tax changes may show more pronounced long-term effects compared to short-term effects, such as corporate tax cuts, and a study with a shorter time frame might overlook this aspect. Finally, tax reforms involve multiple components: some taxes may increase while others decrease. This complexity can make it challenging to categorise specific reforms as net increases or decreases in taxes, potentially leading to misconceptions about the influence of taxes on growth.[2]

Due to these factors, most of the recent academic literature focuses on examining unforeseen exogenous shifts in tax policy.[3] Evidence from this area suggests that tax cuts can potentially boost growth. But they fail to consider one important piece of the puzzle - what if these tax cuts are accompanied by cuts to public spending as well, as is the case with the current government policy plans? This is important as the manner in which tax cuts are financed has a notable impact on their long-term growth effects. Tax reductions funded through immediate cuts in unproductive government spending may boost output, whereas those financed by decreases in government investment could hinder output.[4]

Given that public services have faced massive cuts in the past fourteen years, there is practically no space left for the government to cut spending in this area without eroding both the quantity and quality of services.[5] This makes cutting public investment sound like the easiest option to achieve but it comes with risks to future economic growth and business investment.[6] Reducing public investments, that too in an economy that has underinvested for years compared to its peers, sounds like a recipe for disaster. UK’s public investment levels have averaged at just over 2.5% of GDP in this decade while the OECD average is 3.7 per cent.[7] But if not spending cuts, what other way could we balance the lost revenues?

The answer may lie in fiscal innovation. All taxes introduce distortions and inefficiencies in a market economy, but certain types, such as those targeting negative externalities or wealth, can help raise considerable resources without damaging economic activity. A case in point is the implementation of a one-off net wealth tax on millionaire households, earmarked for one-time increases in government spending.[8] Another longer-term example is a capital gains tax which could involve the equalisation of capital gains and income tax as an initial step towards increasing taxes on the largely unearned income generated from assets. In short, we might need to fund tax cuts through other forms of taxation that are less distortionary. As we reflect on the future and the challenges awaiting the next government, it seems that embracing such an eccentric policy mix is the only way out of the economic mess that we are in today.