Monday morning, the internet was abuzz with news that the British pound had fallen to historically low levels against the U.S. dollar. The pound sterling lost nearly 5 percent of its value in early trading, coming close to parity with the dollar, before ultimately stabilizing.
Economists and other commentators around the internet saw this as news that Prime Minister Liz Truss’s new economic plan—announced late last week—may be dead on arrival. While there are some legitimate concerns about the plan, upon closer inspection there is also a lot to like for those on all sides of the political spectrum.
On Friday, Chancellor of the Exchequer Kwasi Kwarteng announced the terms of what some are calling a “mini budget”—an economic agenda for the U.K.’s new conservative government. The policies receiving the most attention are a 45 billion pound tax cut, as well as previously announced energy subsidies valued at 150 billion pounds.
British pound to U.S. dollar exchange rate.
Source: U.S. Federal Reserve
As far as the tax cuts, the top rate category is being eliminated, such that the highest income bracket will fall from 45% to 40%. Meanwhile, the U.K.’s basic income tax rate will fall from 20% to 19%, and the corporate rate will remain unchanged.
If this sounds fairly uncontroversial, that’s probably because it is. The top U.S. federal income tax rate is 37%, and just 10 years ago it was 35%. Moreover, tax revenues in the U.K. are still expected to rise to about 35% of GDP, which is high by historical standards (see figure). Given this, it’s not surprising the budget package is being labelled “mini.”
Concern in the markets seems to stem primarily from the fact that the additional spending and foregone revenue could lead to larger budget deficits. British interest rates have been spiking, and some are expressing worries about inflation.
UK tax revenues as a share of the economy
Source: Institute for Fiscal Studies
These concerns may be overblown, however, for a few reasons. For one thing, as George Mason University economist Tyler Cowen has noted, despite rising yields, real interest rates are negative on a variety of British government bonds, so there is no sign the government won’t be able to pay its debts. And to the extent that inflation results from expansionary fiscal policy, it’s the job of the British central bank—not the new prime minister—to address this problem. Finally, the pound had mostly recovered from its losses by Monday afternoon, so markets seem to be acknowledging that part of the pound’s decline in value was an overreaction.
Still, some are disparagingly referring to Truss’s economic plan as “trickle-down economics,” equating it with tax-cutting policies associated with U.S. Republican administrations. Rather than take this as a criticism, however, Truss and her team of advisers should wear the label as a badge of honor.
Most economists acknowledge that innovation is one of the primary drivers of economic growth. Innovation tends to occur in a trickle-down fashion—taking place unevenly by affecting productivity and incomes in some sectors before others.
Think about the invention of the automobile, lightbulb, or personal computer. Some people have access to these technologies first, and only later does everyone else get access too. If anything, we want more trickle-down innovation to address older energy sources and a lack of modern, efficient living spaces. The U.K. government has, to its credit, set a 2.5 percent growth target. You can argue whether that’s achievable, but one can hardly criticize Truss for her ambition.
That all said, there are some legitimate concerns about the new U.K. economic proposals. For one thing, while tax cuts are an effective way to spur investment, they can also lead to government borrowing that displaces investment elsewhere in the economy. A useful rule of thumb is for tax cuts to be offset with corresponding spending cuts. The Truss plan doesn’t do that, so U.K. reformers would be wise to focus attention on reducing regulatory burdens, before cutting taxes.
Fortunately, regulatory reform is a pillar of Liz Truss’s economic program. The government is creating as many as 24 new “investment zones” across the country. In these areas, a variety of different taxes and regulations will be lowered or eliminated, including business taxes, taxes on land and properties, and taxes on machinery and building construction, as well as national insurance contributions.
Perhaps most exciting are plans to roll back planning regulations in order to boost building. You wouldn’t know it from the commentary on Twitter, but these are exactly the kind of zoning and permitting reforms that supporters of “supply side progressivism”—a moderate left-wing economic movement—often advocate for.
According to the Guardian newspaper, building-height restrictions, affordable housing regulations, and environmental rules are all potentially on the chopping block. These kinds of policies discourage building and drive up housing prices, contributing to the U.K.’s ongoing housing crisis and keeping people in older, more energy-intensive living and commuting situations.
The area where the new prime minister’s plan may deserve the most criticism is with respect to a two-year freeze in energy prices announced earlier this month. This is where the bulk of borrowing will come from, and it’s not obvious how much good the freeze will do if all it does is increase demand for energy while doing little to address supply.
That said, the new government is planning to enact some supply side energy reforms, including issuing more oil leases, lifting restrictions on fracking, and expanding nuclear, wind and solar development.
All told, the new economic program outlined by Liz Truss and her team hardly warrants the kind of market overreaction we saw over the weekend. Many policies under discussion are ones moderate left-leaning intellectuals often support—at least when not proposed by conservative governments. Their silence suggests their support for progressive policies may be more contingent on politics than on progress.