Will the UK’s economic bet pay off?

The so-called ‘tax event’ on September 23 saw Kwasi Kwarteng, the UK’s new Chancellor of the Exchequer, announce tax cuts and deregulation measures aimed at boosting the growth prospects of the UK economy. The Chancellor also indicated that further tax cuts would be included in the full budget to be unveiled later.

The initial reaction from the bond and money markets was dramatic and demonstrated a staggering lack of confidence in Prime Minister Liz Truss’ fiscal agenda. Investors are rightly worried about the impact of tax largesse on the country’s public finances.

Unfunded tax cuts and large energy subsidies will also help boost aggregate demand, even as the Bank of England tries to cut spending to ease inflationary pressures. The disconnect between fiscal and monetary policy is likely to add to already high levels of economic uncertainty and complicate the ongoing fight against high inflation.

While Kwarteng and Truss hope for a re-reading of 1980s Thatcherism or Reaganomics, recent economic research suggests that the UK economy is unlikely to see a significant increase in productive capacity.

Does the trickle down economy work in the real world? The short answer is no. Economic studies indicate that the tax cuts instituted in recent decades have primarily boosted the fortunes of high net worth individuals and large corporations and exacerbated income and wealth inequality. Moreover, tax cuts aimed at the wealthiest have not generated widespread benefits for the real economy as a whole.

Economists David Hope and Julian Limberg undertook an in-depth study using “data from 18 OECD countries over the past five decades to estimate the causal effect of deep 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 greater income inequality in both the short and medium term. On the other hand, such reforms do not have a significant effect on economic growth or unemployment.

At the same time, a recent meta-analysis by economists Sebastian Gechert and Philipp Heimberger seems to indicate that there is no strong and consistent 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 recent nuanced theoretical literature on growth”.

Multinational corporations often engage in global tax arbitrage which significantly reduces their tax bills. The “Double Irish Dutch Sandwich” and other tax avoidance transfer pricing strategies enable many of the largest and most profitable companies to significantly reduce their taxes globally. As such, reductions in corporate tax rates have minimal impact on large corporations. In fact, the proposed minimum global taxation could 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 at the wealthy could pay off. The marginal propensity to consume is low for wealthy households—that is, the wealthy save a greater share of their income than the poor, and therefore additional dollars of after-tax income accruing to wealthy households will boost the accumulation of savings which can then be deployed to generate productive investments.

In fact, during the first two decades of the 21st century, most advanced economies recorded levels of real investment that roughly corresponded to desired investments. In the United States, investment booms have not materialized following large tax cuts (such as the Bush tax cuts in the early 2000s or the Trump tax cut in 2017) . Instead, they have led to widening budget deficits, soaring levels of public debt and a sharp rise in inequality. This should offer Trussonomics lovers some warning.

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

Improving human and physical capital can help boost the UK economy over the long term. Reforming the education system (improving the quality and rigor of study programs and promoting technical skills training programs should help improve the quality of the national workforce) and the immigration system (boosting the skilled immigration while limiting/controlling low-skilled immigration) capital and increasing productivity levels.

On the physical capital side, infrastructure improvements and increased reliance on automation are expected to help boost productivity levels in the UK. Clearly, the British economy has failed to create enough houses, roads, reservoirs and power stations in recent decades. This in turn has generated extreme levels of geographic inequality. Moreover, excessive financialization has led to investments that are more speculative than productive.

Since 2008, rising income/wealth inequality, economic and political uncertainty, and muted expectations about 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 government led by Liz Truss undertook structural reforms aimed at boosting productivity and improving the potential growth rate of the UK economy.

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