Will the UK’s economic gamble pay off?

The so-called “fiscal event” on Sept. 23 saw Kwasi Kwarteng, the United Kingdom’s newly appointed chancellor of the Exchequer, announce tax breaks and deregulatory measures aimed at reviving the growth prospects of the British economy. The chancellor also indicated that more tax cuts will be forthcoming in the full budget to be unveiled later.

Initial reaction from the bond and currency markets was dramatic and demonstrated a stunning lack of confidence in the fiscal agenda of Prime Minister Liz Truss. Investors are rightly concerned about the impact of the fiscal largess on the country’s public finances.

Unfunded tax cuts and substantial energy subsidies will also act to boost aggregate demand even as the Bank of England is attempting to curtail spending to ease inflationary pressures. The disconnect between fiscal and monetary policy is likely to add to already heightened levels of economic uncertainty and complicate the ongoing battle against high inflation.

While Kwarteng and Truss are hoping for a replay of 1980s-era Thatcherism or Reaganomics, recent economic research suggests that the British economy is unlikely to experience a significant boost to its productive capacity.

Does trickle-down economics work in the real world? The short answer is no. Economic studies indicate that tax cuts instituted in recent decades mostly boosted the fortunes of wealthy individuals and large corporations and exacerbated income and wealth inequality. Furthermore, tax cuts aimed at the well-off failed to generate widespread benefits for the broader real economy.

Economists David Hope and Julian Limberg undertook a comprehensive study using “data from 18 OECD countries over the last five decades to estimate the causal effect of major tax cuts for the rich on income inequality, economic growth, and unemployment.” Their recently published findings indicate that “tax cuts for the rich lead to higher income inequality in both the short- and medium-term. In contrast, such reforms do not have any significant effect on economic growth or unemployment.”

Meanwhile, a recent meta-analysis by economists Sebastian Gechert and Philipp Heimberger appears to indicate that there is no consistently strong relationship between corporate tax cuts and economic growth. They observe that their “finding that the average effect of corporate tax cuts on growth is zero with some variance for individual cases is broadly consistent with the nuanced recent theoretical growth literature.”

Multinational corporations often engage in global tax arbitrage that dramatically lowers their tax bills. “Double Irish Dutch Sandwich” and other such tax-avoiding transfer pricing strategies allow many of the largest and most profitable firms to sharply lower their worldwide taxes. As such, cuts to headline corporate tax rates have minimal impact on the major businesses. In fact, the proposed minimum global taxation may be the first step towards leveling the playing field and avoiding international tax competition that results in a “race to the bottom.”

In theory, if there was a substantial gap between desired investment and actual investment due to a scarcity of savings, then a tax cut targeted towards the wealthy might bear fruit. The marginal propensity to consume is low for rich households — that is, the rich save a greater share of their income than the poor, and, consequently, additional dollars of after-tax income accruing to well-off households will boost savings accumulation that can then be deployed towards generating productive investments.

In reality, during the first two decades of the 21st century, most advanced economies saw actual investment levels that were roughly in line with desired investment. In the U.S., investment booms failed to materialize in the aftermath of major tax cuts (such as the Bush tax cuts of early 2000s or the Trump tax cut in 2017). Instead, they led to a widening of budget deficits, a spike in public debt levels and a sharp increase in inequality. This should offer a warning to those enamored with Trussonomics.

Even ultra-accommodative monetary policy measures instituted in the aftermath of the 2008 financial crisis failed to lead to an investment-led economic growth revival in the UK and elsewhere. Clearly, the problems facing the UK are more structural in nature and cannot be fixed by fiscal or monetary largesse.

Improving human capital and physical capital may help boost the British economy over the long run. Reforming the education system (improving the quality and rigor of the curriculum and promoting technical skills training programs should help boost the quality of the domestic workforce) and the immigration system (boosting skilled immigration while limiting/controlling low-skilled immigration) should help improve human capital and raise productivity levels. 

On the physical capital front, infrastructure improvements and greater reliance on automation should help boost productivity levels in the UK. Clearly, the British economy has failed to create a sufficient number of houses, roads, reservoirs and power stations in recent decades. This in turn has generated extreme levels of geographic inequality. Furthermore, excessive financialization has led to more speculative rather than productive investments.

Since 2008, rising income/wealth inequality, economic and policy uncertainty, and subdued expectations regarding future aggregate demand growth have all contributed to low levels of actual and desired investment. This has contributed to chronically low productivity, which in turn has limited the actual and potential growth rate of the UK economy.

Instead of relying on tax cuts, the UK economy would be better served if the Liz Truss-led government undertook structural reforms that were aimed at boosting productivity and enhancing the potential growth rate of the British economy.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.