Wednesday, 12 November 2008

Should Taxes Be Cut ?

I know an economics graduate and she once told me that if a politician said the answer was to cut taxes, there was a good chance said politician didn't understand the question.

In the same vein, with all three main party leaders now arguing or advocating tax cuts, I'm tempted to wonder if our political leaders have collectively and individually lost the plot and it appears I'm not alone.

The current economic crisis/downturn/recession (delete as appropriate) has taken us into a new period and political policy has been slow to reflect that. The initial response to the onset of recession was to evoke (inaccuately) the memory of John Maynard Keynes. According to the "new Keynesians", the only way to boost the economy was through massive and sustained Government spending. Such spending had hauled the United States out of Depression and would do the same now.

This is of course flawed. First, it is historically inaccurate and second, the global economy of 2008-09 is very different from that of 1929-30.

The other huge problem is the disastrous overblown spending of the Blair/Brown years has left the public finances in a shambles and national debt rising sharply which is exactly where most economists say you shouldn't be at the onset of a recession. To simply add more debt and borrowing to an already over-extended public finance would be the equivalent of throwing petrol on a perfectly good fire.

The critics of this approach rightly stated that whatever short-term stimulus such a plan MIGHT provide would be wiped out by the crippling interest charges and repayments and the inflationary pressures these would cause.

For a few days, the new Keynesians were in the ascendant but a ferocious backlash swept that aside and into town rode a new "white knight", the tax cut. The new orthodoxy, which was based on some of Barack Obama's pronouncements, stated that tax cuts would provide the stimulus the economy needed. To be fair, the Liberal Democrats have been advocating tax cuts for a couple of years but now everyone is an unreconstructed tax-cutter.

But will this work either ? In my view, it's probably too late to prevent a severe recession taking hold over the next 6-12 months and the problem is demands on public finances grow in recessions just as the amount of tax coming in declines. To further reduce that income by cutting taxes in the hope that might stimulate the economy seems risky in the extreme.

It seems to me that, perverse as it may seem, the best policy would be to do what Sir Geoffrey Howe did in his 1981 Budget which is credited (by Thatcherites at any rate) as helping break Britain out of the recession of the late 70s.

In that Budget, spending was cut while taxes were increased. This helped re-balance the public finances at a crucial time and paved the way for more largesse in the mid to late 1980s backed by privatisation.

None of this will be popular and therein lies the problem for Alastair Darling and indeed for George Osborne, his Conservative counterpart. To advocate tax increases AND spending cuts will bring down opprobium aplenty but sometimes doing what's right isn't the same as taking the easy option.

In many ways, the true test of a politician is to take a decision knowing it's both right in the long-term and unpopular now. The other solutions of excessive spending AND tax cutting are predicated on short-term considerations of popularity - that doesn't make them right.

The recession WILL be severe and painful for millions of people. Insecurity and fear already rule the land and thousands of jobs are going to be lost. For those who keep their jobs, however, the downturn will be manageable and indeed the falls in interest rates and food/fuel prices might look quite advantageous in a few months time. Only the absence of cheap credit will be a reminder that the "good times" of 1992-2007 are gone and unlikely to return anytime soon.

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