Why the government should take a long view on the Covid debt and support growth

The Chancellor, Rishi Sunak, revealed in his Budget plans to raise taxes a Treasury-led panic to pay off the Covid debt as soon as possible. This was then supported by gloomy forecasts for the public finances from the OBR, warning that rising interest rates could make them even worse. 

This makes no sense. The debt ratio will come down steadily over time as growth resumes, with some inflation seemingly all set to accompany it. If one corrects the OBR forecasts to a more central trajectory for GDP, such as that of the Bank of England, the improvement in the finances is striking.  Rising GDP raises tax revenue and lowers benefit payouts sharply.

Of course we do not know how long exactly it will take to bring the debt ratio down to sustainable levels below 60%.  But this does not really matter; the key point for solvency is that the underlying direction should be downwards. After the Napoleonic Wars when the ratio reached 200%, it took almost the whole Victorian century to do so. After WW2 when it was around 150%, it took a half century until 2000.

The condition for solvency is that the value of the debt must be at least  equal to (ie backed by) the present value of future revenues net of non-interest spending, the ‘primary surplus’.  With a bit of simple maths this can be shown to be equivalent to saying that the primary surplus as a fraction of the debt must exceed the real rate of interest minus the growth rate; this in turn means the debt ratio is expected to fall steadily in the long run. At present with real interest rates negative and growth strong post-Covid the condition for solvency is plainly over-satisfied.  But of course real interest rates will rise in the next few years, with inflation threatening; and growth will settle back to its normal rate.

Nevertheless two things emerge from present trends. The first is that with our flexible labour market employment is likely to revive sharply with post-Covid recovery, just as it did after the financial crisis.  This is likely to deliver 2% trend growth, which happens to also be the pre-Covid average growth rate in the thirty years to 2019; in that figure productivity slowed down, while employment growth compensated. However, there is evidence from around the world suggesting that productivity measurement  has been biased downwards by not picking up the effects of new computer-based products such as the mobile phone.

The second is the need for the government to support growth with new policies boosting entrepreneurship and innovation. It is already committed to a new-pro-growth approach to regulation, which is very welcome.   But there is ample evidence that growth also depends on tax rates, particularly marginal tax rates on businesses and their owners.  It would be tragic if these were put up just as there is maximum need to get the economy going strongly after the Covid episode, not speak of making it maximally attractive to post-Brexit investors. Far from raising taxes soon, this is the right moment for putting forward a bold agenda for cuts in key tax rates and an infrastructure-building programme, especially oriented to the North, which also according to our regional research benefits most strongly from the tax-cutting agenda..

In my research team’s latest forecasts we have projected the public finances on existing policies (minus the ill-considered tax rise plans) and also with this bold fiscal agenda. Under existing policies, the debt ratio comes down to around 50% by the mid-2030s. With the fiscal package, costing £100 billion a year from 2024, growth is boosted by 1% and the debt ratio falls to around 45%; in effect the package pays for itself.

In sum, the large Covid debt is no reason to rush around in panic to pay it off with higher taxes. On the contrary, with the UK’s strong solvency history, we should take our time and let growth bring it down over time, meanwhile doing what is necessary to ensure the strongest possible growth trajectory in the coming decade.

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