As the Conservative leadership race is in full swing, many contestants are coming forward with promises to cut taxes. Keeping these promises, however, could be harmful in the long term, says AJ Bell head of investment analysis Laith Khalaf.
It is perhaps unsurprising that politicians try to please the electorate with tax cuts, but now is a particularly dangerous time to play with fire, according to Khalaf.
As attractive as tax cuts might be for today’s consumers, who are struggling with a deepening cost-of-life crisis, the current inflationary climate is likely be the wrench in the works of any fiscal easing from the government.
This is because impact of fiscal policy is a key input into monetary policy decisions. The Bank of England (BoE), which is desperately trying to pour cold water on inflationary pressures, is watching the Tory race very closely, looking for signs that would trigger the need for a hawkish intervention.
Tax cuts could be one of such signs, as they would likely set inflation alight again and, as a consequence, force the BoE to turn even more hawkish.
This dynamic is particularly evident when it comes to the prospect of an income tax relief, which Khalaf described as “a particularly sticky lever” because of the future political challenges to switch it back to the level it was before the cut.
The last time it was raised in the UK was as far back as 1975, when chancellor Denis Healey approved an ‘anti-inflation surcharge’ at 35%, increasing it from the previous 33%.
“If the next prime minister does press ahead with a cut to the basic rate of income tax and that subsequently results in higher inflation, the risk is they then lack the political capital to backtrack, leaving the BoE to play bad cop by hiking interest rates instead,” noted Khalaf.
According to AJ’s investment analysis head, reductions in VAT and corporation tax would have a similar effect, exerting upward pressure on inflation the former by encouraging consumer spending and the latter by generating a wage-price spiral. Both cases would make it more that the BoE has to step in.
Luckily, while the BoE’s committee is scheduled to meet on 4 August, with an expected rate raise of at least 25 basis points, Khalaf does not think consumers should be too worried about a further increase just yet.
“The new government’s fiscal policy isn’t likely to feature in the Bank of England’s decision-making until it is writ in stone, perhaps at an Autumn Budget after the Conservative leadership contest is concluded.”
It will all depend on the new Tory leader and their fiscal stance.
Should it be too indulgent towards the consumers of today, the risk remains that any extra cash they get in their pockets from a tax windfall today, would be swallowed up by higher mortgage and loan payments tomorrow.
“The combined effect could be a bit like robbing Peter simply to pay Peter,” said Khalaf.