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Image Source: WSJ
Image Source: WSJ
It was only a week ago on 23 September, the Chancellor of the Exchequer Kwasi Kwarteng announced a 45 billion pound tax cut on the floor of the House of Commons in the UK. What followed was a fall in the pound to an all-time low of 1.034 on 26 September, a loss in confidence in the government’s new budget deficit, and a sell-off of British assets. Liz Truss, the new Prime Minister of the UK has received immense criticism over the government’s decision to cut taxes. In this paper, I will be analyzing the state of the UK’s struggling economy, the market fears, and what the future holds.
Britain's economy is overheating due to high demand and huge government spending during the pandemic under Boris Johnson’s government. Moreover, Vladimir Putin has been pressurizing European countries to abandon Ukraine by hindering the supply of natural gas which has increased gas prices substantially. To counter inflation and save consumers from rising energy bills, the government took down the “top rate of 45 percent of income tax applied to those earning more than 150,000 pounds.” (Merced) Right after the announcement by Kwarteng on Friday, the financial market took a hit with UK bonds plummeting, a massive sell-off, and a fall in the pound’s value reaching parity with the dollar.
Liz Truss is adopting Ronald Reagan’s tax cut policy of 1980 which did not result in drastic economic growth. According to Paul Krugman, a Nobel Memorial Prize winner in Economic Sciences, “the proposition that tax cuts for the rich strongly increase economic growth has no evidence.” It is a pattern of failure which has been observed in several states in the United States, for example, Kansas and Mississippi. In fact, if compared to the economy under Bill Clinton under whom tax cuts were reversed you can clearly see faster economic growth.
Another reason for the backlash against the budget deficits is the lack of confidence in the Truss government. Usually, when countries increase government borrowings it leads to a hike in interest rates to counter inflation which further encourages foreign investment. This inflow of capital from abroad strengthens domestic currency. However, the opposite occurred after the tax cuts when the pound fell in the face of rising interest rates. The market behavior reflects investors' apprehensions about the government's ability to maintain large budget deficits which is a cost of increased borrowings. Further, the crash in pounds value led to a 65 billion pound bailout by the Bank of England to prevent the pension funds from collapsing as stated in BBC News. This added fire to investors' disbelief in the success of the government's “Mini Budget.”
In 1976 England was facing a similar situation known as the Sterling crisis when inflation, budget deficits, and the 1973 oil crisis drove the government to borrow 3.9 billion dollars from the International Monetary Fund, the largest loan to be requested at the time from IMF. (Pettinger) Today, the Bank of England seems to be reaching the same crossroads and is hesitant to raise interest rates to avoid repeating history. Therefore, the government's decision is considered irrational considering the inflationary state of the economy.
It is time to adopt new economic policies and ditch the traditional approach of tax cuts which has time and again failed to uplift the economy. What England needs right now is a strong economic plan aimed to protect the currency’s value and manage the rising inflation.
Sources:
Wonking Out: The Tax-Cut Zombie Attacks Britain
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