Corporation tax – is Rishi Sunak having a Laff(er curve)?

It was Private Eye, perhaps unsurprisingly, who nailed the Conservative U-turn on corporation tax rates. They note Boris Johnson’s quote at the Conservative leadership hustings on 5 July 2019 that;

Every time corporation tax rates have been cut in this country it has produced more revenue.

Perhaps Rishi Sunak wasn’t listening, or perhaps he thinks that the Laffer curve is a bit old hat, but the proposed increase in corporation tax effectively reverses most of the Coalition Government’s cuts in tax rates – George Osborne inherited a basic rate of 28% and a small profits rate of 21%. If the Laffer curve is credible, and previous Conservative claims were accurate, that might suggest that revenue from corporation tax will drop over the coming years.

One might expect a fall over the next few years anyway, with extremely generous incentives for capital investment and relaxed rules for carrying back losses – particularly salient given the damage done to so many businesses by the pandemic and the resultant restrictions on business activity. However, the Budget forecasts suggest that the rates change will raise an additional £11.9 billion in 2023-24, £16.25 billion in 2024-25 and £17.2 billion in 2025-26 compared to what might have been expected otherwise.

Let’s put that into context. Corporation tax revenues in the 2019-20 fiscal year totalled £48.4 billion, and are expected to return to that level in 2022-23. They are then predicted to rise to £71.3 billion in 2023-24, £81.7 billion in 2024-25 and £85.3 billion in 2025-26. So, either Laffer was wrong, or George Osborne was or, perhaps, there are some pretty heroic assumptions in terms of the impact of Brexit. And George doesn’t think that he was wrong

We’ll see, especially given that if the increase in revenue doesn’t materialise, the gap will have to be filled somehow.

Admittedly, the rate changes were pretty well signposted. In late August, the Sunday Times reported that Rishi Sunak was considering four things in terms of tax changes;

  • an increase in the rate of corporation tax to 24% from the current 19%
  • a resetting of capital gains tax rates to reflect the equivalent rates of income tax, effectively treating them as additional income
  • changing the way that company dividends are taxed – currently the tax system encourages companies to pay their directors in dividends rather than through a salary as dividends aren’t charged for National Insurance purposes
  • restricting the rate of tax relief on pension contributions to 30%

He has clearly delivered on the first of those, one which has least direct impact on the personal finances of voters.

Capital gains tax rates are currently slightly lower than income tax rates, although the rates are charged as though the assessable gains are income, with available unused personal rate bands utilised to calculate liability, and thus changing the rates to match those for income tax wouldn’t be a vast change.

Changes to company taxation, and in particular, the taxation of dividends, would be painful for a minority, but might not be too risky politically – would those affected punish the Government by shifting leftwards?

Steve Webb, the former Liberal Democrat Pensions minister, is convinced that the Government will seek to reduce the cost of pension tax relief – £37 billion per annum – and it would be politically easier to abolish higher rate relief than to reduce it across the board. Indeed, offering relief at 30% across the board would still be cheaper than the current position.

So, potentially interesting times ahead in taxation policy, although Rishi Sunak will probably hoping that the Prime Minister gig comes his way before this Budget goes sour…

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36 Comments

  • Peter Martin 15th Mar '21 - 11:14am

    ” If the Laffer curve is credible, and previous Conservative claims were accurate….”

    It isn’t when you look at the bigger picture.

    On a simple level it would be possible to optimise the tax on say, cigarettes, or petrol, or alcohol to produce the maximum revenue. But that’s probably not what you want. There are other considerations.

    In any case if people spending too much on cigarettes they’ll be spending less on VATable items like clothing, holidays and electrical goods so your total extra revenue will not be as much as you might anticipate.

    Similarly, if you maximise your revenue from Corporation tax that will probably be as a result of clever accountants using a tax, which probably too low, as a way of minimising other taxes such as capital gains and income taxes.

  • Peter Davies 15th Mar '21 - 12:02pm

    “Capital gains tax rates are currently slightly lower than income tax rates”. They are currently only half the rate of standard or higher rate income tax. You don’t even need a very clever accountant to work out how to use this to remove half your tax liability.

  • Joseph Bourke 15th Mar '21 - 12:05pm

    Good article, Mark and salient for thinking around LibDem policy. When we are talking about the Laffer curve, it is important to remember it is a curve and not a linear relationship. That taxpayers alter their behaviour in response to rising marginal tax rates is not disputed in the academic literature. The issue is that no one is quite sure where the optimal rate that maximises tax yields lies.
    When I was training as an accountant back in the 1970s, the highest rate of income tax was 83% and on investment income it was 98%. We were undoubtedly on the wrong side of the Laffer curve at that time and higher earners were relocating to lower tax juridictions in their droves. In many ways those rates are what drove a major expansion of the tax avoidance industry. First for high net worth individuals and subsequently for multi-national companies.
    I doubt we are on the wrong-side of the Laffer curve with respect to any of the tax rates in the UK today and won’t be with a 25% corporation tax rate. We might still be with respect to the benefits withdrawal rate.
    This budget can be broken down into three phases. The recovery from the pandemic in 2021-22 for which circa £65 billion has been provided. A £25 billion stimulus to bring forward business investment in the form of a super-deduction over the next two years (If this had not been done may firms would have delayed investment to 2023-24 to reduce their tax bills when corporation tax was increased). The third phase is fiscal consolidation of circa £30 billion over three years in the form of a higher corporation tax take.
    The fundamental issues remain unchanged. Demographics are continually increasing the size of the retired population that is dependent on a proportionally smaller workforce. Healthcare, social care and pension spending is going to continue increasing at a faster rate than economic growth and spending on public health spending is unlikely to stop by spring next year as the budget indicates.. It is clear that Schools. Local authorities and prisons and justice systems have been cut beyond their capacity to maintain adequate levels of services. Working age benefits have been eroded to the point of destitution for many. Taxation policy is going to have to play a crucial part in addressing these issues.

  • Peter Martin 15th Mar '21 - 12:19pm

    @ Joe Bourke,

    “The issue is that no one is quite sure where the optimal rate that maximises tax yields lies.”

    That’s ‘cos there isn’t one.

    Neoliberals do seem to have a blind spot on taxes. There really isn’t any such thing as a tax “yield”. Except, perhaps, for your local council. There isn’t for a currency issuing government.

    Any positive rate of tax will ensure that all money spent by the Government will end up being taxed out of existence sooner or later. To this extent the yield is always 100%. This doesn’t say anything about anything else in the economy. If tax rates are too low relative to the levels of total spending we’ll have an inflation rate which is too high.

  • Part of the problem here is over-simplification (not least by Rishi Sunak). It’s not just the tax rate that matters, it’s also the tax base.

    So, over the last 10+ years corporation tax rates have certainly come down but the tax base has expanded significantly: far fewer and less generous reliefs, including around losses, interest deductibility and capex. That is a significant part of the reason why the tax take (in absolute terms) has increased significantly all the time the rate has been coming down.

    Now we have a major jump in the CT rate (the largest jump since the 1960s) BUT no corresponding narrowing of the tax base. That means:
    a) this is by far the biggest increase in the CT burden in decades; and
    b) the overall CT burden in the UK will now (from 2023) be higher than that in the US, Germany and most of the G7 (let alone the G20), so the UK looks uncompetitive. A fact not lost on international businesses when they choose where to make investments.

    Why should we care? Well, for one thing, discouraging investment by business means a knock-on loss in jobs and employment taxes, as well as future corporate tax receipts.

    For another thing, companies (ultimately) don’t “bear” the cost of corporate taxes. These taxes are ultimately borne by a combination of shareholders (so pension funds, life assurance funds etc), employees, customers and suppliers.

    So Sunak’s corporation tax raid is a stealth tax in more way than one … but in the long-term, likely to diminish overall tax revenues.

  • I think the following short article from Tax Journal explains the point clearly, including a very helpful chart from the Office of Budget Responsibility:
    https://www.taxjournal.com/articles/the-corporation-tax-rate-rise

  • Laurence Cox 15th Mar '21 - 1:53pm

    I have always followed Harold Wilson’s “The £ in your pocket” principle. No matter how you came by it: whether by working, by unearned (savings) income, or by making capital gains; it buys exactly the same, so should be subject to the same rate of tax.

    To my way of thinking, we should start by merging Income tax and NI, which we can do if we eliminate the existing contributory Basic State Pension and replace it with a non-contributory Basic State Pension (additions to the State Pension like SERPS would have to remain for those who had already accumulated them). This has been Party Policy since 2004, although Clegg and the leaders who followed him kept it out of the 2010 and subsequent manifestos. As the standard rate of income tax would then be 32%, we could simply restrict tax relief on pensions to the standard rate.

    The trouble with the Laffer curve is that while it is self-evidently true at both ends (0% and 100%) this tells us nothing about the tax rate that optimises yield. Rather than George Osborne or Richie Sunak, I prefer to follow Geoffrey Howe. As Margaret Thatcher’s first Chancellor he reduced the top rate of income tax to 60%, where it remained for most of her premiership. Even now, people earning between £100k and £125k pay a marginal rate of 60% from withdrawal of personal allowance, so it is clearly not a serious disincentive. Our Basic Income proposals would require elimination of the Personal Income Tax allowance, so unless we chose to make an already wealthy group even better off we would need to raise the tax rate.

    People like Peter Martin, who think that the tax yield is always 100%, are assuming a completely closed economy, not our open market economy. Once money is outside the UK it is effectively out of reach of HMRC, otherwise tax havens would not exist.

  • Joseph Bourke 15th Mar '21 - 2:08pm

    Dominic,

    important points about the tax base and noting that it is the effective tax rate that matters for investment rather than the headline rate. Having said that there is considerable evidence that tax rates are not the key drivers of FDI. Other factors like access to a skilled workforce and open markets carry more weight. As regards domestic investment, growing demand is a more important factor than effective tax rates. Maintaining internationally competitive rates is important, but you have to look at the tax burden in the round including rates of dividend tax on corporate profits after tax.
    There is no doubt that spurring business investment is an essential element of business recovery. That is done, however, with a strategic program of public investment and maintaining consumer demand in line with a growing base of capital stock.
    The macro-economic impact of tax policy is only one side of the coin. Equally important are the distributive effects, not least to maintain a broad base of consumer demand in the economy and counter the deflationary effects of high concentrations of wealth.
    One thing we should be taking a look at is the Mirrlees review recommendations:
    “It makes sense to tax most business income before it leaves the company, through corporation tax. But we should reduce the personal tax rates on corporate-source income (dividend income and capital gains on shares) by the same amount to reflect the corporation tax already paid. The combined rates of corporate and shareholder taxation should equal the tax rates levied on employment and other sources of income. ”
    “Saving and investment are costs associated with generating future income. This can be
    recognised in one of two ways:
    • Cash saved or invested can be treated as a deductible expense when it arises, as currently applied to personal saving in the case of pension contributions and to business investment in limited cases where 100 per cent first-year allowances are available.
    • A deduction could be given each year for the opportunity cost of capital previously saved/invested. This is the rate-of-return allowance (RRA) treatment of saving and the allowance for corporate equity (ACE) treatment of business investment, neither of which has ever been used in the UK although both are now used in other countries.”

  • Peter Martin 15th Mar '21 - 2:37pm

    @ Laurence Cox,

    “People like Peter Martin, who think that the tax yield is always 100%, are assuming a completely.. Once money is outside the UK it is effectively out of reach of HMRC. ”

    No I’m not.

    Think about. The Government spends a pound into the economy – thereby creating a new pound. It will either end up in the hands of someone who wants to spend it in the UK economy or wants to save it. It doesn’t really matter if they are overseas and outside the reach of the HMRC. It can only be spent in the UK. Or swapped for a different currency but then whoever ends up with it will have the same two choices. Save or spend in the UK.

    Once spent it will be part of the first and subsequent transactions. And it will be subject to various forms of tax on each transaction. It will dwindle down to 90p, 80p etc as it goes along and some of it gets caught up in the tax net. Eventually they’ll be nothing left. That’s why it is 100%.

    Unless, perhaps, someone permanently loses it down the sofa, or burns it as part of a Bullingdon style initiation ceremony, in front of a homeless person. That’s just like paying tax anyway.

  • Joseph Bourke – don’t disagree on several of those points, tax is clearly not the sole driver of investment decisions, but it is a significant one. It’s also more nuanced than just the tax burden: as the article I linked to pointed out, business craves stability and predictability. The UK seems all over the place: 12 months ago we were anticipating a corporation tax rate of 17%; now it’s intended to increase to 25%, a near 50% increase relative to expectations!

    Of course in the ‘knowledge economy’, access to skills is critical/usually more important than tax. But the UK has just deliberately put itself at a competitive disadvantage in that respect as a result of Brexit: not just in terms of actual limitations on the single market/freedom of movement, but also in creating a perception that it is no longer a welcoming place for talent.

    Ireland and the Netherlands (as two good examples) have been able to attract investment not just because of their domestic talent pools, alongside fiscally attractive regimes, but because they are well placed to attract talent from across Europe (& beyond). The UK has decided to forfeit the advantage it used to have.

    In that context, tax has a (relatively) bigger role to play, so this Budget feels particularly badly-timed …

  • Steve Trevethan 15th Mar '21 - 2:51pm

    Here is an article which analyses the “Laffer Curve” and explains how it can work/appear to work in the short term.

    https://braveneweurope.com/frances-coppola-the-abominable-laffer-curve

    P.S. Might it be more efficient for the most of us if a proportion of corporation shares were allocated to a government instead of the complexities etc. involved the collection of taxes, as suggested by the economist Dean Baker?

  • Joseph Bourke 15th Mar '21 - 2:58pm

    Peter Martin,

    tax is not solely related to recovery of government spending in the economy on public goods and services. A large proportion of tax raised relates to transfer payments Transfer payments are a redistribution of income and wealth such as welfare, overseas financial aid, social security, and government subsidies for certain businesses. They serve as a reallocation of money created by banks to acquire resources produced in the private sector by the working population to the non-working population. Without effective tax collection there can be no system of state pensions or social security.

  • Peter Martin 15th Mar '21 - 3:18pm

    @ Joe Bourke,

    “tax is not solely related to recovery of government spending in the economy on public goods and services. ….. Without effective tax collection there can be no system of state pensions or social security.”

    These are exactly the same points that I’m always attempting to get across. The government doesn’t need to ‘recover’ what it can create without limit. It does, however, need an effective system of taxes to stop us spending what we might otherwise want to spend. This gives it the fiscal room to spend itself on pension and social security, amongst other things that it might like to spend some of its created money on.

  • Peter Martin,

    bank reserves or base money can be created without limit by the BofE. However, the broad money supply (i.e. the money that actually circulates in the economy) is only increased by bank lending or running government deficits. And there are limits to both of these.
    A budget sets out government tax and spending plans. Currently, they assume an ongoing budget deficit of 3% (close to nominal GDP growth and largely to finance capital spending) once we are out of the pandemic and recovery is underway. The OBR projection suggests consumer spending will quickly recover to pre-pandemic levels and the output gap will be largely closed within two years of exiting lockdown with a somewhat higher level of structural unemployment. It is the extent of the output gap that will determine fiscal room and hence the need for matching spending with taxation.
    This is what budgets and forecasts do. Instead of simply increasing spending across the board in the hope that deflationary forces will counteract inflation and then having to introduce emergency budgets to raise taxes and/or interest rates if they do not: it allows the government to plan ahead for increased levels of tax and borrowing that may be needed.

  • Peter Martin 15th Mar '21 - 8:13pm

    @ Joe B,

    “A budget sets out government tax and spending plans. …….This is what budgets and forecasts do…….. allows the government to plan ahead for increased levels of tax and borrowing that may be needed.”

    I must say it all sounds marvellous. We have teams of very clever people using the latest up-to-date economic models and making such accurate forecasts that any signs of future problems are nipped in the bud at a very early stage. So, short of a new dangerous virus or large asteroid strike, our economy only ever improves over the longer term.

    If only it were like that. The forecasting of the mainstream is hopeless. Even the Queen has noticed. She asked why the 2008 GFC wasn’t foreseen by the mainstream. When the Met office fails to forecast something big, like missing the 1988 hurricane, people do tend to notice the next day. But because economic forecasts are made over a period of years everyone has forgotten about them by the time something completely different happens.

    You’ve quoted some OBR forecast recently. Make a note of what they’ve said in a notebook so you won’t forget. Don’t lose the book and see how well they’ve worked out in 5 years time.

  • Peter Martin,

    economic forecasts typically contain a range of optimistic, pessimistic and central forecast and are updated with current information to reflect changing economic conditions. The further out they go the less accurate they are likely to be. That applies with any forecasting model.
    Mark Valladares highlights in his article potential future tax changes that may be under consideration in the near future including;
    – a resetting of capital gains tax rates to reflect the equivalent rates of income tax, effectively treating them as additional income
    – changing the way that company dividends are taxed – currently the tax system encourages companies to pay their directors in dividends rather than through a salary as dividends aren’t charged for National Insurance purposes
    – restricting the rate of tax relief on pension contributions to 30%
    These changes, if adopted, would feature in a manifesto together with an estimate of the tax yield and any additional spending planned within an overall fiscal framework that is regularly produced and updated by the OBR.
    Over the course of the past year the BofE has been acquiring medium term government gilts and swapping them for cash reserves that pay bank base rate while the treasury has been selling new short-term debt. This has reduced nominal interest costs, but also reduced the average maturity of gilts held by market participants down to 4 years, increasing the treasury’s exposure to short-term interest rates https://www.reuters.com/article/uk-britain-economy-obr-idUSKBN2B026R. While interest rates are not a concern at present that may not always be the case and both the Bank of England and OBR forecasts serve to provide a guide to the direction of travel of interest rates.

  • Peter Martin 16th Mar '21 - 10:37am

    “While interest rates are not a concern at present that may not always be the case and both the Bank of England and OBR forecasts serve to provide a guide to the direction of travel of interest rates.”

    This argument is based on the incorrect view, sometimes known as the “crowding out theory”, that Government and the Private Sector are in competition for the same pool of money which is available for lending. So interest rates are low now, according to this theory, it is because neither the Private nor Govt Sectors want to borrow much.

    This is obviously not true at all. Interest rates are low because the Govt wants them low is the only theory which fits the known facts! The direction of travel of interest rates has been steadily downward for several decades now. That’s why they are close to zero in all the developed economies. Govts have pursued the same “New Keynesian” line that a reduction in interest rates will stimulate the economy.

    That’s true. It does. But it’s only a temporary stimulus. A reduction in interest rates also leads to a build up of private sector debt which then causes debt deflation. So we have to have another reduction to offset the debt deflation caused by the previous interest rate reduction!

    I happen to agree with you that if we have a inflation target of 2% we should also have interest rates at close 2% too. Ideally. But we can’t simply put them back up. It’s easy to lower interest rates. It’s much harder to put them back up without crashing the economy. All governments know this and this is why it won’t happen. At least if they have sense it won’t! The governments of the currency issuing countries are in full control of the level of interest rates.

  • Peter Martin,

    The reuters article linked above writes:
    “Last week the OBR also warned that government spending on debt interest was highly sensitive to any further rise in interest rates.
    Benchmark 10-year government bond yields had jumped to a one-year high of 0.8% by the time of the budget, up from 0.3% at the start of February, as part of a global surge in bond yields driven by expectations of faster growth and inflation.
    Charlie Bean, a former Bank of England deputy governor who now sits on the OBR’s board, said he was comfortable with the OBR’s main forecast that interest rates would not rise much further.
    “What I would not do is extrapolate from the recent couple of weeks to say: ‘That is a trend that is going to continue, we will see markedly higher interest rates in the second half of this year’,” Bean said.
    The exact impact of higher interest rates on the public finances also depended heavily on whether they were accompanied by higher growth and inflation, which would boost tax revenues, he added.”
    I think that is a reasonable assessment and there are no immediate concerns around the affordability of interest payments. If interest rates do rise it will be because nominal growth is higher than projected.
    What is of immediate concern is the long-term funding of public services, particularly in areas that have seen big cuts over the past decade like local authority finance and working age benefits. Additionally, those areas where costs keep rising in excess of economic growth like health and social care and pensions that require long-term funding strategies.
    The rise in corporation tax is likely just the first of the tax measures in this Parliament. As Mark writes in his article “potentially interesting times ahead in taxation policy”. We seem to have come to a position where it is the Conservatives advocating future tax rises to meet public service commitments and the Labour party opposing them. Funny old world isn’t it!

  • Joseph Bourke 16th Mar '21 - 4:31pm

    Laurence Cox,

    the office for tax simplification agrees with much of the proposals you outline https://www.gov.uk/government/publications/ots-capital-gains-tax-review-simplifying-by-design
    The issue under debate appears to be the efficacy or otherwise of raising taxes and/or cutting spending when annualised real economic growth is projected to be around 1.6% to 1.7%. The corporation tax hikes and freezing of personal allowances are expected to move around 30 billion or so of spending from the private sector to the public sector. The budget deficit is projected to fall to 4% of gross domestic product in 2023/24 from 19% of GDP in 2020/21.
    The argument being made is that neither tax rises or a slowdown in the rate of increase in spending (it would accelerate instead) should be implemented and that the deficit should be ignored until inflation is running consistently above target or whatever is considered an acceptable level. It is hoped that this policy would reduce unemployment from the projected level of 4.4% in 2024 to somewhere closer to 3% and possibly, but not necessarily, increase the long-term level of real growth from the lower levels of the past decade.
    The problem, as I see it, is that long-term growth rates have fallen across the developed world and come to a standstill in Japan which is the closest approximation we have to such a policy. Perhaps the Biden stimulus will furnish some real world evidence as to the efficacy or otherwise of such a policy approach.

  • Peter Martin 17th Mar '21 - 9:48am

    @ Joe,

    Are you suggesting that we should be surprised that a very neoliberally inclined organisation like the OBR should be issuing very neoliberally inclined warnings about interest rates?

    But the facts are clear. Interest rates are now ultra low because the Govt wants them ultra low. The process started in the aftermath of the GFC and has continued as a policy response to the Covid Pandemic.

    Short term rates as simply decided by a policy committee in the supposedly, not not factually, independent BoE. Longer term rates are determined largely by the amount of QE which has the sole purpose of lowering them to what they are now.

    You and I are not currency issuing Govts. We can be concerned that interest rates are outside our control. The Government need not have such concerns. If interest rates have to rise it is because the Govt wants them to.

  • Joseph Bourke 17th Mar '21 - 1:29pm

    Peter Martin,

    I would suggest that the OBR is largely independent of political bias. It is therefore, able to bring a level of of objectivity to its assessment of economic trends and likely consumer and business behaviour in a way that labour party members with a particular political agenda and bias cannot.

    Interest rates are now ultra low not because the Govt wants them ultra low, but because they have been forced there by deflationary global market conditions. Central banks react to financial market conditions and manage monetary policy accordingly.

    It is relatively easy decision for central banks and governments to cut interest rates, lower taxes and increase spending to stimulate economic activity. It is much more politically difficult to increase interest rates, raise taxes or cut spending to manage inflation expectations and foreign exchange risk. Government’s don’t take such actions because they want to get themselves thrown out of office. They do so because they have no alternative but to react to market conditions and will often try to time such actions in the aftermath of an election. If possible, to give the public time to forget about the economic hardship inflicted before the next election rolls around.

    If interest rates rise, it will not be because the Govt wants them to or not. It will be because growth in bank lending and nominal GDP growth forces them up. It doesn’t make interest costs unaffordable for the reasons the OBR notes, but has knock-on effects in the financial and housing markets and across the real economy, that can depress investment and real economic growth if a rise is too rapid.

    Tax policy is not difficult to understand. If you want good quality public services and a resilient social security system look to the Nordic model and the role that taxation plays in delivering the level of public services the Scandinavian countries enjoy.

  • Peter Martin 17th Mar '21 - 9:02pm

    @ Joe B,

    “If interest rates rise, it will not be because the Govt wants them to or not It will be because growth in bank lending and nominal GDP growth forces them up. ”

    Nonsense.

    Look. The Govt can borrow as much as it like from the BoE at 0% interest. This is what it has effectively done with its QE program. This has meant that interest rates for all of us are ultra low too.

    Now, it may be that there are good reasons for not doing this so much in the future. There have been many who’ve said they shouldn’t have done this so much in the past. It is a matter of choice and considered opinion as to the optimal level of interest rates to suit world conditions at some future time. No one is forcing the Govt to do anything.

  • Joseph Bourke 18th Mar '21 - 12:08am

    Peter Martin,

    “The Govt can borrow as much as it like from the BoE at 0% interest”. That may be the case, but it cannot spend it into the economy when consumer spending and bank lending is rapidly increasing.
    The OBR sets out the position with this commentary on Debt maturity, quantitative easing and interest rate sensitivity https://obr.uk/box/debt-maturity-quantitative-easing-and-interest-rate-sensitivity/
    “To illustrate the potential fiscal impact of an increase in interest rates, if short- and long-term interest rates were both 1 percentage point higher than the rates used in our forecast – a level that would still be very low by historical standards – it would increase debt interest spending by £20.8 billion (0.8 per cent of GDP) in 2025-26. To put this into context, it is roughly equivalent to two-thirds of the medium-term fiscal tightening announced by the Chancellor in this Budget.”
    “In isolation, such a rise in interest rates would therefore make the task of keeping debt on a sustainable path more difficult. But debt sustainability is also affected by the level of debt, the rate of growth in GDP and the primary balance, so any assessment of the broader fiscal risks posed by greater interest rate sensitivity also needs to take on board the reason for the increase in interest rates:

    – In a benign scenario where the increase in interest rates reflects higher economic growth, the debt stock could ultimately be lower and the primary balance more favourable, all resulting in a virtuous fiscal circle.
    – But malign scenarios are possible too. If interest rates rise because investors demand a higher risk premium for some reason, this would be more likely to be accompanied by a deteriorating economic and fiscal position, resulting in a vicious fiscal circle. In such circumstances, governments can find it difficult to make the spending cuts and tax rises necessary to restore the debt trajectory to a sustainable path.”

    Central banks can choose where to set interest rates, but it is underlying economic conditions and exposure to inflation and foreign exchange risks that determine that choice. Turkey, for example, sets it rate at 17% and Argentina at 38% due to their economic circumstances. While the Bank of England can control base rates, it doesn’t have control over underlying economic conditions and must ultimately react to changes in those conditions.

  • Peter Martin 18th Mar '21 - 3:30am

    @ Joe,

    It looks like we are coming around to saying (some of) the same things,

    Yes, the government can do certain things, like keeping the QE program going, but it probably shouldn’t IF consumer spending and borrowing is rising rapidly. Argentina and Turkey have chosen to set their interest rates at very high levels. Whether they should be quite this high is, again, a matter of opinion but if inflation is an issue they clearly have to do something.

    It would. perhaps, be better for them to concentrate on having a an effective system of taxation so they didn’t have an inflation problem in the first place.

    It all comes down to levels of inflation. If inflation rises and the economy starts to overheat there will be a case for higher interest rates. But if levels of private sector debt are very high, as they are now, and as they were before the GFC you don’t want to convert high levels of private sector debt into high levels of bad private sector debt. That will bring on another crash. So it needs to be done much more carefully than it was before 2008. Governments shouldn’t make the same mistake twice.

    Again, inflation has to be factored into the picture regarding the cost of public sector debt. If the inflation rate is equal to the interest rate it is effectively zero no matter what these numbers might be. We’ve had higher levels of both inflation and interest rates before. There economy was arguably running much better then but getting it back to what we had isn’t going to be possible any time soon.

  • Peter Martin 18th Mar '21 - 3:58am

    ” I would suggest that the OBR is largely independent of political bias”

    You cannot be serious!

    This is the big problem for economics profession. Political bias is so pervasive that it prevents the normal process of discussion and debate leading to a consensus, as happens in other academic disciplines, or at least something close to it. There will be no consensus in economics until there is a consensus on politics. ie Probably never.

    The OBR was set up by the Tories , and Lib Dems, after the 2010 election as a cover for their program of economic austerity. Except it was austerity for the public sector but a policy of anything goes for the private sector with ultra low interest rates to encourage everyone else to do the borrowing that Govt wasn’t prepared to.

    Economic austerity can be a valid counter inflation policy but it isn’t a deficit reduction policy. The problem for the Government is that if they cut their spending they also cut their own revenue. So the deficit stays roughly the same unless they can encourage us all to spend more by borrowing more which keeps their revenue levels up.

    I can’t imagine that the highly educated and highly paid members of the OBR don’t know this. If they are so “independent” why can’t they acknowledge what they have been advocating?

  • Joseph Bourke 18th Mar '21 - 12:03pm

    Peter Martin,

    the Office for Budget Responsibility (OBR), like the operational independence of the BofE, has become a central part of the UK’s fiscal framework. These institutional arrangements gives confidence to market participants and opposition parties that there are some grown-ups keeping an eye on things.
    The OBR gives independent and authoritative analysis of the UK’s public finances. It is an executive non-departmental public body, sponsored by HM Treasury. It is one of a growing number of official independent fiscal watchdogs around the world including the much larger congressional budget office in the USA.
    There is a formal memorandum of understanding for working with government departments which begins https://obr.uk/docs/dlm_uploads/obr_memorandum040411.pdf “The OBR must be independent and expert—and perceived as such—in order to provide credible fiscal and economic forecasts and scrutiny of the long term sustainability of the public finances.”
    The OBR specifically does not advocate policy. They make an independent evaluation of the impact of government policy.
    There is a broad consensus in mainstream macro-economics and that certainly does not advocate reducing total government spending or raising the overall burden of taxation during an economic downturn. That does not mean that governments cannot rearrange spending priorities between departments, or that some taxes cannot be increased while others are reduced. They are distributional changes within the overall tax and spend framework, not macro-economic changes in the overall fiscal framework.

  • Peter Martin 18th Mar '21 - 12:40pm

    @ Joe B,

    You might be thinking that I should be more respectful of, and deferring to, mainstream opinion when it comes to macroeconomics. Normally, with any other academic discipline, I would. I’m not even sure the word ‘discipline’ applies in Economics.

    This is Prof Bill Mitchell, who’s much better qualified than either of us, being equally disrespectful of the of the OBR and Laura Kuenssberg too!

    LK: “… what lurks on the country’s balance sheet is the biggest economic baggage for generations.”

    BM: Financially-constrained corporations and households have balance sheets. The concept has no real meaning for a currency-issuing government.

    She continued to show her macroeconomic illiteracy:

    LK: But the enormous debts that have been racked up for good reasons leave us vulnerable to tiny changes in interest rates that the government can’t control.

    BM: She was just repeating what the boss of the OBR was mouthing. One illiterate to another.

    In other words we have a Professor of Economics calling the head of the OBR and LK “economic illiterates”. As you’re saying pretty much the same thing, that would also apply to you.

    Possibly, I might disagree with Bill slightly here. I think the UBR do understand a lot more than they are prepared to admit. It’s not been perfect, but they and the government have done a much better job of keeping the economy going than I would have previously expected them to. So they must know what is possible when it’s needed. They just don’t want to the rest of us to know too!

    http://bilbo.economicoutlook.net/blog/?p=46442

  • Peter Martin 18th Mar '21 - 1:04pm

    @ Joe B,

    If you expect anyone to show more respect for the OBR you really need to make a convincing argument that they’ve been value for money.

    This is the sort of thing that I expected and wasn’t difficult to find in one of their first reports. Nov 2010

    “We expect current policies to deliver a sufficiently large primary budget surplus by 2015-16 to put public sector net debt on a clear downward trajectory”

    Bill Mitchell would have told everyone for free that a budget surplus, ‘primary’ or otherwise, wasn’t a realistic option for a net importing country like the UK.

    It wouldn’t have been so bad if they’d explained that they were concerned that the UK economy was overheating and some deflationary fiscal policies were in order.

    and what about this?

    “Over the medium term, we expect growth to accelerate to 2.6 per cent in 2012
    and 2.9 per cent in 2013, before slowing to 2.7 per cent in 2014 and 2015….”

    At the time of writing the UK growth rate was 1.9%. If you’d stopped people at random on the streets and asked them to make a prediction for the next 5 years they would likely have done better. So what are we getting for our money?

    https://obr.uk/docs/dlm_uploads/econ_fiscal_outlook_291110.pdf

  • Joseph Bourke 18th Mar '21 - 1:37pm

    Bill Mitchell appears to think anyone who does not agree with his framing of economic problems is an economic illiterate. That is a somewhat unusual position for an academic reliant on peer review to take.
    In the real world treasury officials are responsible for maintaining the stability of the currency and financial markets and policy is based on lived experience and a great deal of uncertainty.
    The USA has injected a broad based fiscal stimulus into their economy. If that spurs an investment boom that adds productive capacity to the economy that increases the potential GDP and adds to current demand for goods and services, the results will be benign. However, a big part of that may well end up invested in existing tech shares inflating the stock market bubble even further. Another big chunk may be spent on imported Chinese goods which Chinese investors might well recycle a good part of into the US housing market making the problem of housing affordability even greater for younger US residents. This is what happens with a broad untargeted stimulus. The impact are widespread and come with unintended consequences.
    If it goes wrong and the USA has to raise interest rates to cool down an overheating economy then what will that do to UK interest rates? Do you think the BofE can hold base rate at 0.1% when rates are 1% or 2% in the USA? The BofE will have to follow or rely on QE to buy treasury bond issues as there would be few other buyers. That is the real world and why Keynes emphasised animal spirits and the importance of being able to distinguish between uncertainty and measurable risk.

  • Joseph Bourke 18th Mar '21 - 3:57pm

    Peter Martin,

    “We expect current policies to deliver a sufficiently large primary budget surplus by 2015-16 to put public sector net debt on a clear downward trajectory”

    If real growth is projected to be in a range of 2.6% to 2.9% and the inflation rate 2% than nominal growth is the range of 4.6% to 4.9%.
    If, as in recent years, growth rates exceed interest rates then a primary surplus reduces debt as a proportion of GDP. The UK’s debt to GDP % began to fall in 2018 and 2019 when the UK was running a primary surplus and unemployment had fallen to 3.8%.

    “Over the medium term, we expect growth to accelerate to 2.6 per cent in 2012 and 2.9 per cent in 2013, before slowing to 2.7 per cent in 2014 and 2015….”

    Growth did actually return accelerate to 2.9% in 2014 . The under performance compared to past recoveries has been attributed to the so called “productivity puzzle” i.e. anticipated productivity gains have not materialised.

    There are good reasons for stimulating economic activity during recessions. There are equally good reasons to end stimulus (outside of automatic stabilisers) when the economy returns to a stable path. At that point the focus moves on from demand management to productive investment aimed at solving the ‘productivity puzzle’ and tax based redistribution.

  • Charles Smith 18th Mar '21 - 7:50pm

    Chancellor Rishi Sunak will go ahead with changes to IR35, which will come into effect in April despite widespread calls for the policy to be pushed back to a later date. The reform is designed to ensure private sector employers are responsible for assessing whether or not contractors need to pay income tax and national insurance contributions. It is also aimed at preventing tax avoidance by “disguised employees” – contractors with permanent positions at companies without paying the same tax or national insurance as standard employees. However, some self-employed workers fear that the changes will see the private sector take a risk averse strategy and wrongly place contractors under the regulations.
    https://worldabcnews.com/self-employed-warning-rishi-sunak-set-to-slash-incomes-with-ir35-move-personal-finance-finance/

  • Peter Martin 19th Mar '21 - 11:41am

    @ JoeB,

    “If it (the Biden fiscal stimulus) goes wrong and the USA has to raise interest rates to cool down an overheating economy …..”

    Let’s just be clear what you’re saying here. You are suggesting that there is a possibility of the USA’s fiscal policy being too loose which could then lead to overheating and inflation. Correct so far. But why does that have to lead to an increase in interest rates? If a Govt presses too hard on the accelerator, surely the first thing to do is stop pressing quite so hard rather than slam the brakes on?

    “If, as in recent years, growth rates exceed interest rates then a primary surplus reduces debt as a proportion of GDP.”

    In typical neoliberal fashion you use the word “debt” to indicate Government debt. All the emphasis is on that but the extent of debt in the private sector is ignored. It’s the same in the EU. Lots of rules about Govt debt but none at all about private debt.

    I’m not sure what is your point in the sentence starting with the word ‘if’. We can all play ‘what if ‘ games! There wasn’t a primary surplus and nor should there have been any ambition to achieve one.

  • Joseph Bourke 19th Mar '21 - 12:55pm

    Peter Martin,

    you write above “we have a Professor of Economics calling the head of the OBR and LK (Laura Kungsberg) “economic illiterates”. As you’re saying pretty much the same thing, that would also apply to you.” Then you put these statements forward as examples of your evidence for making these assertions.

    “We expect current policies to deliver a sufficiently large primary budget surplus by 2015-16 to put public sector net debt on a clear downward trajectory”

    “Bill Mitchell would have told everyone for free that a budget surplus, ‘primary’ or otherwise, wasn’t a realistic option for a net importing country like the UK.”

    It is then pointed out to you that the UK was running a primary surplus in 2018-19 as this FT article reports https://www.ft.com/content/fc22a2fe-45a0-11e9-a965-23d669740bfb
    “The Office for Budget Responsibility also notes that…Britain will run a primary surplus in 2018-19, meaning that tax revenue covers all of the government’s spending needs apart from interest on past debt.
    Since becoming chancellor, Mr Hammond has halved the deficit from 2.3 per cent of GDP in 2016-17 to 1.1 per cent in 2018-19, with further progress to 0.5 per cent by 2023-24 forecast by the OBR.”

    Even after it is pointed out to you that the UK was running a primary surplus before the pandemic, you still insist there wasn’t a primary surplus.
    Despite continually being shown to be factually wrong , like Donald Trump, you continue trying to deny facts.
    This is the point of the OBR. To cut through this kind of propaganda (whether it comes from Labour or Conservative party members or eccentric Economic professors who should know better) and present facts, together with objective projections based on economic trends.

  • Joseph Bourke 19th Mar '21 - 2:22pm

    Peter Martin,

    You ask above with respect to the US stimulus – If a Govt presses too hard on the accelerator, surely the first thing to do is stop pressing quite so hard rather than slam the brakes on? The simple answer is it is too late once stimulus checks have gone out to change your mind. Having increased welfare to reduce child poverty, why would it make sense to reverse the decision? It would not. Just as it does not make sense to withdraw the £20 per week uplift to Universal credit in the UK. You increase interest rates to slow credit expansion and increase taxes to maintain the higher levels of welfare spending.
    You also say “you use the word “debt” to indicate Government debt.” Again this is not the case. Government policy to control inflation is focused on total debt – private and public. Public debt can increase without creating inflation pressure to offset deleveraging or excess saving in the private sector. This is what happens in a recession and what has been happening in Japan for three decades as firms and households have gradually sought to pay down the enormous levels of credit issued to fund the stock market and property booms of the late 1980s. What cannot be done is expansion of public debt and private sector debt at the same time in excess of the supply capacity of the economy. When the economy is growing at a stable pace, total debt can only increase broadly in line with expanded supply – both capital and labor. If it increases beyond that level then the purchasing power of the currency declines and living standards with it.
    When unemployment falls to around the 4% to 4.5% level you come up against structural issues not demand deficiency. It needs to be addressed with structural measures such as the youth job guarantees proposed by the Alliance for Full Employment https://affe.co.uk/ or TUC https://www.tuc.org.uk/news/tuc-demands-job-guarantee-scheme-stop-long-term-unemployment

  • Peter Martin 20th Mar '21 - 4:07am

    @ Joe,

    There are sensible ways of adjusting fiscal policy to regulate the economy. VAT can be lowered to loosen it. It can be raised to tighten it. The duty on petrol, cigarettes and alcohol can be varied. The support provided by central government to local councils can be increased or decreased etc.

    Such variation should be as smooth as possible and not be too abrupt. The analogy with driving a car is a valid one in this respect. We’re all taught to control a car’s speed with the accelerator as much as possible and not to drive on our brakes. In any case, you don’t normally press down the accelerator and apply the brakes at the the same time.

    Raising interest rates as a first response is being far too abrupt. Have governments learned nothing from the 2008 GFC ? It was the raising of interest rates which converted high levels of private debt into high levels of bad private debt and caused an economic crash. The effects of which we are still struggling with today.

    Governments should decide where they want interest rates to be. 0%, 1%, 2% or whatever. Any increase towards a higher figure should be slow. Once there they should be left there and the economy regulated by fiscal adjustments.

  • Peter Martin 20th Mar '21 - 4:08am

    cont/

    “Government policy to control inflation is focused on total debt – private and public.”

    This is clearly not the case. We are told often enough that Govt debt is about £2 trillion or getting on for 100% of GDP. So what’s the extent of private debt? To find out simply Google “private debt in the UK economy”

    and we find:

    “Private Debt to GDP in the United Kingdom averaged 204.09 percent from 1995 until 2019, reaching an all time high of 238 percent in 2008 and a record low of 154.50 percent in 1997.”

    So who knew this? If they did they might have realised that raising interest rates in the years before 2008 to try to lower private sector debt levels wasn’t a smart idea. We can’t simply reduce our personal or company debt levels as a response to higher priced loans in the same way we can reduce our car mileage if we can’t afford the petrol. All we can do is declare bankruptcy which does have knock on effects in the rest of the economy!

    In other words, private debt is twice as high as Govt debt. But which one gets more than twice the attention? Go figure!

    If you look at the historical record you’ll find private sector debt falls as public sector debt increases. This is what happened after the GFC and needed to happen to correct the imbalance. Where else was the money going to come from? An export boom? Good luck with getting everyone to be like Germany by running a huge export surplus!

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