Leadership race tax cut plans could stoke inflation & prompt further rate hikes – Laith Khalaf

by | Jul 12, 2022

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Laith Khalaf, financial analyst AJ Bell
  • Tax cuts could stoke inflation and force the Bank of England to hike rates more aggressively.
  • Income tax is particularly difficult to tamper with and cut may be hard to reverse.
  • Consumers could find any tax windfall eaten up by higher mortgage payments.

Laith Khalaf, head of investment analysis, AJ Bell: “With most of the Tory leadership hopefuls standing on a platform of tax cuts, the Bank of England will be watching very closely as the race unfolds.

“Fiscal policy is a key input into monetary policy decisions, and while the Bank of England is desperately trying to pour cold water on inflationary pressures, sweeping tax cuts could set them alight again.

“Tax cuts taken in isolation are clearly positive for today’s consumers, but in the current inflationary climate, any fiscal easing from the government could simply lead to greater monetary tightening from the Bank of England. Consumers might therefore find that any extra cash they get in their pockets from a tax windfall is swallowed up by higher mortgage and loan payments. The combined effect could be a bit like robbing Peter simply to pay Peter.

“The basic rate of income tax is a particularly sticky lever to tamper with because it becomes politically challenging to move it in the opposite direction again once the rate is cut. The last time the main basic rate of income tax was raised in the UK was in 1975, when the Chancellor at the time, Denis Healey, increased the rate from 33% to 35%. He referred to it as an ‘anti-inflation surcharge’, viewing it as a necessary step to curb wage inflation. 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 Bank of England to play bad cop by hiking interest rates instead.

“A cut to VAT would, on the face of it, have a one-off dampening effect on inflation. Although that would ultimately be reversed if the cut was only temporary, and it could eventually exert upward pressure on inflation over the longer term by encouraging consumer spending. Likewise, cutting corporation tax would put more money in the pockets of businesses, allowing them to pay more to workers in an already incredibly tight labour market. This risks a wage-price spiral taking off, deepening the inflationary bind the country finds itself in and requiring further intervention from the Bank of England.

“Data released by Moneyfacts this week shows that average two and five year fixed mortgage rates experienced their largest month-on-month increase since their records began in 2007. Of course, fixed mortgage customers won’t feel the burn until they have to renew their deals, but there could be a shock in store when they come to do so. The average two year fix now stands at 3.74%, up from 2.34% last December, according to Moneyfacts.

“The Bank’s interest rate committee is already expected to raise rates by at least 0.25% at its forthcoming meeting on 4th August. Beyond that base rate is then forecast to rise to over 3% next year (according to Refinitiv data). 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. But when it does, it could mean the interest rate committee turns more hawkish.

“There is also the issue of how tax cuts are funded, which needs to be considered. If that’s through higher debt, the question is whether the additional burden on future generations of taxpayers is a fair one.”

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