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Why Liz Truss's fiscal policy was right


Despite her monumental political missteps leading hers to the shortest Prime Ministerial tenure in history - 45 days - the fiscal policies of Truss and her equally short-lived Chancellor, Kwazi Karteng - were actually the correct ones. She adopted a classical Keynesian approach to economic doldrums, and in due course the government of British Prime Minister Rishi Sunak is going to have to do the same thing. While Truss's short-lived government was condemned for being radically right-wing in its fiscal priorities, in fact it was a Keynesian centrist approach that embodied substantial common sense.


Our purpose here is not to investigate or dwell upon the political blunders on the part of Liz Truss that brought her administration to so ignominiously rapid a conclusion. Headline writers have already spilled enough ink on that subject. Instead we are going to investigate, through an economist's lens, the logic of her so-called 'mini-budget' of 23 September 2022, that has been commonly perceived to have been the catalyst that brought down her government. We argue that had this budget been presented in the right way (which it was not - it was presented catastrophically badly by two inexperienced politicians), it should have been accepted as obviously the right medicine for the British economy in its current pitiable state.



The mini-budget consisted of the following components.


  1. Reduction in the basic rate of income tax (charged on annual income between approximately GBP12,500 and GBP50,000) from 20 per cent to 19 per cent.

  2. Abolish the higher rate of income tax of 45 per cent typically payable on annual income over GBP150,000.

  3. Reducing corporation tax from 25 per cent to 19 per cent.

  4. Abolition of a previously announced national insurance (a sort of British statutory social insurance fund) rates from 12 per cent and 2 per cent (higher tier) to 13.25 per cent and 3.25 per cent.


What Truss and Kwarteng took note of, a concept in economics that few politicians truly understand, is that beyond certain rates of tax you actually start raising exponentially less tax revenues. That is because the higher the tax rate the less motivated the tax payer will be to increasingly productive economic activity. Moreover the level of tax raised is always less than the amount of money that same money would produce if left in the private economy, because it is a cardinal tenet of microeconomics that persons and entities in circumstances of fair competition are more efficient than state owned entities in what they do. That is why so-called 'command economies (e.g. socialist systems) lag far behind their market economy counterparts, mutatis mutandis. The higher the tax collections as a proportion of GDP, the closer an economy comes to being a command economy and the increasingly sclerotic it becomes as market dynamism is corroded.


Moreover modern empirical scholarship suggests that as progressive rates of taxation increase, the corresponding quantity of tax actually collected tails off and can even go backwards. That is because there are far fewer wealthy people (those who pay progressive rates of taxation) than there are ordinary people; therefore the quantity of tax these wealthy people pay is miniscule as a proportion of the whole; wealthy people are more intelligent and more skilled in the arts of tax evasion and avoidance; therefore ever more money must be spent in tax investigations, inspections and enquiries to collect an ever-diminishing pot; and wealthy people have access to tax lawyers, a ceaselessly inventive profession that thrives upon finding the loopholes that exist in all tax legislation and always have done.


This is due to the greater efficiency of the private sector versus the public sector in the legal profession as much as in anything else: private tax lawyers are more ingenious and inventive than government tax lawyers because they are better paid and hence the private sector attracts brighter tax lawyers than the public sector. It has always been so, and this has resulted in an unbroken circle of drafting and redrafting ever longer pieces of tax legislation intended to close loopholes, only for tax lawyers to find new loopholes There will always be more, the more complex the tax code becomes as there ever more opportunities for oversight in drafting), followed by further amendments and further loopholes; and so on and so forth. At present we see this game played out in international taxation and the preparation of ever more complex corporate structures to minimise the effect of the latest international tax treaties.


For all these reasons a prudent government knows that (a) there is an optimal level of taxation and raising taxation above that level will produce increasingly piddling revenues for the Exchequer; and (b) tax rises in general reduce economic productivity, and hence is something to be avoided during periods of recession, depression or sluggish growth.


However one thing a government contemplating Keynesian economic stimulus to recover from recession should never do is borrow money on the international financial markets in foreign currencies. Do this, and when your domestic currency devalues you cannot service the interest on the foreign currency denominated debt and you default on it. This leads to hyper-inflation, best illustrated by the experience of the Weimar Republic in the early 1920's.


In his treatise General Theory of Employment Interest and Money (1936), Keynes prescribed that you do not raise taxes during a recession, as increasing taxes serves as what economists call a 'deadweight loss' to the economy as a hole, deterring economically useful activity (a person or corporation is less motivated to make money, the more they know that whatever income or profit they make will be eaten by tax). Instead you lower taxes, to stimulate economic growth; and you pay for this with a relaxation of monetary policy (that is to say, printing more banknotes or introducing more money into the system). This will devalue the currency, making your economy more internationally competitive and thereby also stimulating growth.


By contrast you raise taxes and tighten monetary policy in times of economic surplus, to provide for social and national needs and to redress the balance after a period of recession has to come to an end, thereby restoring your currency's credibility in the international markets and enabling you to import more - whereas in recession you want to export more so you want a currency with a lower value.


Truss's fiscal policy was half of Keynesianism; the other half, relaxation of monetary policy, would surely have followed had her government stayed in power. Actually theirs was an orthodox Labour Party policy, rejecting the monetarism of Milton Friedman and the University of Chicago (of which this author is a graduate). Yet they were slated for being too right-wing in their thinking. If anything they were too left-wing. As the political process leading to Prime Minister Truss's despatch proceeded, nobody stood up to say the obvious: that she was pursuing an orthodox Keynesian fiscal policy which makes perfectly logical sense. Now the dust has settled, we consider it appropriate that someone points out the true economic realities of the situation. Truss's government may have been politically incompetent but it was not economically incompetent.


In response to recession, Prime Minister Sunak has adopted a Monetarist approach of tjeclind advocated by Margaret Thatcher I'm the early 1980's. Monetarism envisages that monetary policy (i.e. how much money the government produces) is the principal driver of economic growth. If you keep your money supply tight and under control, then the economy will readjust to the restricted smount of money available and this sense of macroeconomic stability will increase international investments in an economy. The problems with monetarism during a recession are that the readjustment of the economy anticipated involves contraction to fit the areas of the economy in which the country under monetarist treatment has an international comparative advantage; the rest of the economy will contract; many people will lose their jobs or have their salaries and incomes reduced as a result; there will be widespread social deprivation and this may lead to social unrest, as the economy adjusts in the dramatic way Friedman thinks is necessary amidst recessions.


Moreover by restricting the money supply, the government needs to raise taxes to pay off the country's debts, with all the economically depressive consequences that entails.


Monetarism may work after a few years, if it increases the country's credit grade for international investment - often accompanied by dramatic deregulation of industry sectors. This is what happened in Margaret Thatcher's Big Bang deregulating investment banking in 1986, and it attracted huge quantities of investment capital from across the world. Britain turned a corner and become notoriously prosperous. But years of social dislocation and pain to lower income households were the price paid in the early 1980's before Thatcher's government reaped the rewards of her grand execlrcise in deregulation of industry sectors and, subsequently, privatisation of state owned industry.


When politicians talk of the need to balance books, pull in purse strings, tighten belts, re-establish investment reputations and all similar such claptrap, they are talking the language of right wing conservative Monetarism and it means that they are prepared to execute sharp measures of economic contraction, with consequent mass unemployment, to achieve the Monetarist ideal. This author is not a monetarist - at least, not in circumstances of recession. (Different economic principles may apply in times of rapid economic growth, to attempt to suppress boom-bust cycles; but that issue is beyond the scope of this essay.) This author is a Keynesian, and believes, as with Roosevelt's 'New Deal' policies in the 1930's, that in times of recession governments should be investing in industrial policy (that is, starting acting as an economic actor on its own initiative, such as infrastructure construction) as well as helping businesses take off once more by relieving them of tax and regulation. This should be paid for by relaxing the money supply, reducing the currency's international value and accordingly help exporters.


Of Britain's recent Prime Ministers, Johnson, May and Truss were Keynesians; Sunak is a Monetarist (at least he appears to be so for now.) This, we think, is quite the opposite direction from that in which the United Kingdom ought to be going.


We fear that since the United Kingdom's departure from the European Union on 321 January 2020, a great deal of British economic common sense has been lost in the face of a growing habit for resuscitation of the ideas of mercantilism in the eighteenth century, a now wholly discredited economic doctrine that advocates ensuring one's net exports are higher than one's net imports. While arguably popular with the general public and advocated by a contemporary generation of populist politicians, mercantilism is bad economics because currency fluctuations will adapt to countries' relative economic prosperity and balance everything out in the long run (or even earlier). Hence trying to force industry to produce and export through government-driven Industrial policy is basically a bad idea. Indeed the European Union represents the antithesis of this, the world's biggest free market sustained by the four freedoms: movement of capital, movement of labour, movement of services and movement of goods. Despite its exasperating bureaucratic growth, the European Union is possibly the best economic model ever conceived for nations to cooperate to become mutually wealthier. As we have thrown out the baby, of European Union membership, so it appears we have thrown out the bathwater of sound economic understanding of cross-border trade and how to stimulate it. Indeed British economic policy is now entirely rudderless, our raising taxes when they should be lowered and our causing our population needless suffering by adhering to a strict monetary policy during a period of economic stagnation.


The stagnation can be overcome. It just needs the courage to reread Keynes; and to understand that the key to promoting growrh amidst recession is to lower taxes and loosen monetary policy. Then Britain will start growing again, and she can reinflate her currency later on the wave of that success. The current inchoate course, by contrast, can lead only to poverty and ruin.