The Huge Failure of The Mini Budget
Elizabeth Truss, the new PM and Kwasi Kwarteng, the new chancellor released a “mini budget” last Friday, and there’s a lot to talk about.
·
What was in the mini budget
·
What were/will be its effects
·
My opinions on the mini budget
The mini budget has had a drastic, negative impact on the
economy within a week of its release and within a month of the Truss government
coming to power. So, what is it all about.
Key
points
The mini budget has come with drastic tax cuts, the largest
in the UK since 1972. In terms of income tax[1].
The basic tax rate (for earnings between £12,571 to £50,270) will be cut by 1%,
from 20% to 19% in April 2023 and the top bracket for earnings over £150,000,
45% will be removed, and the highest rate of tax will be 40% for earnings over
£50,270. The removal of which has been cancelled.
Additionally, Stamp duty[2]
has been cut, there is no stamp duty for properties purchased for under
£250,000 and for first time buyers, properties bought for less than £425,000
will have no stamp duty. Furthermore, relief for first time buyers is now
applicable for houses worth £625,000.
The planned 6% hike in corporation tax[3]
will be cancelled and will remain at 19%. The tax cuts are supposed to support
the supply side of the economy and target a growth rate of 2.5%. There will
also be legislation enacted to tackle “militant trade unions” which have been
responsible for many closures and interruptions in the past few months.
Moreover, there will be 40 new “investment zones” where businesses will get tax
breaks. Finally, the limits to the ratio of bonuses to salary that bankers can
earn has been removed. Previously, bankers could not be given bonuses greater
than 200% of their salaries.
What
were/will be its effect?
So far the market has reacted very negatively to this news,
the yield of 10-year gilts[4]
rose to a high of 4.56% on the 28th from 3.31% on the 23rd.
This means that the government’s cost of borrowing has increased significantly.
And may indicate that the market is beginning to doubt the UK government’s
ability to repay its debt. This is because of the UK government increasing its
deficit via major tax cuts after successive economic crises, COVID and now the cost-of-living
crisis.
There has been speculation that this will increase
inequality in the UK, the IMF urged the UK to re-evaluate fiscal policy as it
was “likely to increase inequality and add to pressures pushing up prices.” The
Tory government showed that they support the “trickle down” economic theory which
typically refers to supply side policies however in this sense, it is when
wealth is accumulated by the rich, it is eventually invested back into the
economy, allowing the accelerator effect to increase growth. The current
government has shown their intentions to adopt this theory by reducing the tax
burden on the wealthiest income earners, cutting the cap on bankers’ bonuses,
and increasing the target growth rate to 2.5%.
Moreover, the pound weakened significantly, the price of a
pound fell to its lowest ever point with the US$, as it neared parity (when
£1=$1), at a low of £1=$1.035 a mere 3 days after the budget was announced. As
the US$ is the world reserve, the currency is used in most international
transactions, however, if the pound is weak against the dollar, this will rise
the costs of imports significantly as pounds can buy less dollars, and by
extension, less goods. This is a big issue as the UK runs a trade deficit- it
imports more than it exports, and in the middle of a cost-of-living crisis,
upward pressure on prices is not beneficial.
INFLATION
Finally, the most
important, inflation. There is an existing cost of living crisis as a result of
the mishandling of the COVID pandemic (which I predicted in August 2021), and the
trade bans imposed on Russia due to its war on Ukraine causing energy prices to
skyrocket[5].
However, the mini budget adds more inflationary pressure. This is both directly
and indirectly.
As a direct result of the mini budget, the government has committed
to extremely large boosts in spending relative to tax, boosting aggregate demand
significantly, which typically results in a temporary rise in real GDP and upward
pressure on the price level.
Furthermore, due to the value of the ten-year gilt falling
dramatically, the BOE was forced to step in to protect the pension funds (who
have much of their assets invested in gilts). The BOE did this by quantitative
easing (QE). They printed another £65 billion and bought gilts to artificially
raise their price. And according to Fischer’s equation, MV=PT, an increase in
the money supply (M) will result in an increase in price level (P) since the velocity
of money (V) is proportional to the volume of transfers (T).
Lastly, the pound weakened and since the UK is a net
importing nation, hence due to the weakening exchange rate, imports will become
more expensive as the pound will not have the same international purchasing
power. Resulting in an increase in prices.
What do I
think of the mini budget?
I believe that the mini budget had the right intensions but
the wrong approach. Instead of targeting consumers, I believe that the government
should have relaxed supply side policy. By targeting the consumers, the
government put more money into people’s hands rather than made products cheaper.
It sounds like a good thing to do in a cost-of-living crisis, but people are
spending larger proportions of their income, hence the money given to the
people will be spent. With the multiplier effect kicking in- boosting aggregate
demand significantly (high marginal propensity to consume). This shift in AD
will only add to the existing inflationary pressure, not to mention the additional
pressure caused by the foreign exchange market and the BOE’s quantitative
easing. Due to this inflationary pressure, prices will hike further adding to
the cost-of-living crisis.
The government should have attempted to boost aggregate
supply, make it easier for firms to operate in the UK, hence reducing the price
of various goods. This could have been done by reducing the rate of corporation
tax instead of simply cancelling the hike. They could have also subsidised energy
for businesses instead of just for households, further reducing the costs.
There was no need to reduce taxes and finance the spending through gilts.
This is not mentioning the negative political aspects of
this budget, which includes the Tories looking weak by committing to the U-turn
on the top tax bracket. Furthermore, they appeared corrupt due to Kwasi Kwarteng
attending a champagne party with various bankers after the mini budget. As a result
of the poor calculations and planning, the IMF published a statement for the
chancellor to reconsider UK fiscal policy due to the probability of the mini
budget increasing inequality. This has been political suicide for the Tories.
Overall, I am with the majority, the mini budget has failed to
achieve what it was supposed to, and instead achieved making the majority of
the UK worse off.
[1]
For new readers, income tax is a progressive, marginal tax. Progressive
means that it is beneficial for the poorer groups of society, as the rich bear
most of the tax burden and marginal means that you will be taxed X% for each £Y
you earn, and these have tax brackets where the percentage changes.
[2] Stamp
duty is the tax that people pay when buying a house
[3] Corporation
tax is the tax on businesses’ profit
[4] Gilts
are UK Government bonds, that they sell to raise revenue to finance their
spending.
[5] As
a result of energy being vital to all businesses, the increased price of the
commodity, by default causes upward pressure on prices as a result of increased
costs of production
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