Liz Truss Is Choosing Inflation

Her 'mini-budget' is like if Biden implemented another $1.4 trillion stimulus package.

Dear readers,

Liz Truss, the new prime minister of the United Kingdom, is only nine years older than I am, and like me, she’s spent most of her adult life in a period when governments could borrow and spend with little macroeconomic consequence — interest rates were low and market demand for government bonds was apparently insatiable, and so there was little reason for “hard choices” like tax increases and spending cuts.

Of course, there were tax increases and spending cuts — the UK, like pretty much every other advanced country, enacted both in the years following the global financial crisis. Like most countries, they overdid it, and at the core of Truss’s new economic agenda is an idea that is correct at a sufficient level of abstraction: if the UK finds ways to grow faster, that will improve its long-run fiscal sustainability, and reduce the future need for painful austerity like it endured post-2008.

Unfortunately, she has it all wrong once you start adding in any level of detail.

The reason financial markets reacted so negatively to Truss’s “mini-budget” is simple: It’s a huge fiscal stimulus at exactly the wrong time. Truss is proposing over £160 billion of deficit-increasing policies over the next five years. To give you a sense of scale, since the US economy is approximately eight times the size of Britain’s, the equivalent would be if we implemented an additional $1.4 trillion, five-year stimulus package. And that actually understates the insanity of this policy for Britain, because Britain doesn't have the advantage of issuing the world’s reserve currency (and the inherent stability that comes from that), and because inflation in Britain is even higher than it is here.

UK Prime Minister Liz Truss and the top economic official in her cabinet, Chancellor of the Exchequer Kwasi Kwarteng, visit Berkeley Modular, on September 23, 2022 in Northfleet, England. Truss and Kwarteng have been scrambling to reassure financial markets about the wisdom of their plan to sharply cut taxes and subsidize energy at a time of high inflation. (Dylan Martinez - WPA Pool/Getty Images)

While most of Truss’s plan consists of energy subsidies,¹ £45 billion of the stimulus is allocated to tax cuts not particularly associated with energy. Some of the tax cuts are broad-based: She will cancel a planned increase in national insurance contributions (Britain’s equivalent of payroll tax) and she will cut the basic rate of income tax from 20% to 19%. Some almost entirely benefit the rich: She’ll scrap the top income tax rate of 45% (the new top rate will be 40%) and cancel a planned increase in taxes on dividends. And she’ll also cancel a planned increase in the corporate income tax rate, which is lower in Britain than in most peer countries.²

Truss’s policy announcement caused the pound to tumble against the dollar and the euro (because all that stimulus will be inflationary) and caused interest rates to spike (because the Bank of England will have to raise rates more aggressively than previously expected in order to beat back that added inflationary pressure). And that doesn’t bode well for the economy under Truss.

Forcing the Bank to raise rates higher will raise the cost of capital and discourage the very same business investment she says she’s trying to promote through tax cuts and energy subsidies. Added inflation will make people really angry. And this obviously unsustainable fiscal policy will undermine confidence that tax rates will stay as low as Truss is setting them — which will dampen whatever modest incentive the tax cuts create for businesses to make long-term capital investments.

Truss, and the Tory voters who chose her, can’t say they weren’t warned. Her main opponent in the contest to replace Boris Johnson as leader of the Conservative Party, former Chancellor of the Exchequer Rishi Sunak, said tax cuts would have to wait until after inflation had been tamed. “If we hand the mantle of economic competence to Labour, we’re finished,” he said. Tory party members were unmoved by that warning — they wanted their tax cuts now, as Truss assured them they could have. And, now you can see what has happened.

Truss clearly admires Margaret Thatcher, but when Thatcher took office in 1979, she started cutting Britain’s top personal income tax rate from 83% — the argument that tax cuts will unleash investment is a lot more plausible when tax rates are that high. The truth is that Britain does need to become more competitive, but it’s not the 1970s and taxes are not the main problem with its competitiveness. Britain’s biggest productivity problem has to do with its terrible housing policy — it is far too difficult to add housing units in London, which holds down job growth in the place where workers can be most productive, while burdening households with excessive housing costs.

London’s land-use regime is so destructive of economic value that the blitz was accretive: War damage that destroyed existing buildings made it possible to build new, larger ones where that were otherwise prohibited by policy. I do not advocate indiscriminate bombing of London to grow the UK economy. But if Truss wants to grow Britain’s economy faster, she needs to pursue regulatory changes that make it possible to make investments like the construction of new housing in the places where it’s most needed. In fact, pro-growth deregulation (the new supply-side policy) would soften the blow of the tax increases Truss should be imposing to offset the stimulative effects of the energy subsidy policies she needs to pursue now for geopolitical reasons.

Some of the comparisons going around that say Britain is like an emerging economy in a currency crisis are a bit overblown. I agree with Paul Krugman that “Britain isn’t Argentina” — their government is making a mistake that will hurt the economy and raise inflation, but they’re also a rich country³ with a lot of institutional advantages and they’ll get through this. But the main reason they'll get through it is that this mistake is temporary: Either Truss will capitulate and change her policy after the markets beat her up some more, or a Labour government will do so after elections due by 2024.

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Hotels are the big price transparency offenders. President Biden and his Department of Transportation are proposing to require more price transparency from airlines — airlines would have to provide more detail about optional add-on fees, like checked bag fees, when they first quote an airfare.

I’m not necessarily opposed to a rule like this, though I think airline price transparency is already pretty good — airfares are routinely quoted inclusive of mandatory taxes and fees, and I think airlines (and even more so, third-party airfare booking sites) are pretty good about showing upfront which fares do and do not include checked bags. I take DOT’s point about it being sometimes too hard to figure out exactly what a bag fee will be — customers can be diverted to “confusing charts” showing how fees vary depending on, for example, a customer’s destination and class of service, rather than simply being told what fee will apply to them personally. It would be good to improve that.

I mainly want to note that the airlines are a paragon of fair and clear pricing compared to the hotel industry.

Not only are hotel prices routinely quoted exclusive of taxes and fees⁴, hotel rates are often subject to "resort fees" or "destination fees" that are mandatory add-ons to the room rate, payable to the hotel itself, and yet excluded from the initial rate quote. This should be illegal. If the charge goes to the hotel and is mandatory with the room rental, it should be included in the rate. DOT doesn’t regulate hotels, so they can’t impose transparency regulation in the part of the travel industry where it’s most needed. But it would be an appropriate thing for some arm of the government to do.

I’ll be back tomorrow with the Mayonnaise Clinic.

Best,

Josh

1. Most of the US news coverage about Truss’s package has focused on the tax cut components, but subsidies designed to offset the factors causing energy prices to spike in Europe account for about three-quarters of its five-year cost. Half the subsidies will go to households (on terms that were announced a few weeks ago) and half will be for businesses and other non-household entities. Truss frankly has no good options here — the disruption of Russian energy supplies hits Europe much harder than it hits us, and there needs to be some sort of relief for energy bills that will otherwise be unaffordable for many people and businesses. Truss has faced criticism for refusing options to constrain or offset the cost of the subsidies — for example, she could impose a windfall tax on energy suppliers who gain from high prices and from subsidies that reduce consumers’ incentive to conserve — but even there she faces inherently hard choices. This is exactly the time that Britain wants energy companies to invest in expanding capacity, and jacking up the taxes on their future profits would reduce their incentive for doing so. The genuine difficulty of what to do about energy costs is what makes her broader tax proposals so galling and bizarre.

2. She also plans to cut stamp duty, which is Britain’s real-estate transfer tax. Transfer taxes are bad taxes, especially when charged at rates as high as the ones in Britain — they are an arbitrary tax on people who move more frequently, since they’re paid only upon sale. If you’re going to tax property, you should tax it annually based on value, not at the time of sale. So I’m sympathetic to Truss’s instinct on this issue, if not to her timing.

3. Though you wouldn’t know it by their household appliances and manual-transmission cars.

4. I appreciate that Marriott, and certain third-party sites like Kayak, do have an option to list hotel price quotes inclusive of taxes and fees.