Responding to tax cuts:

The Story of Liz Truss

I have been trying to understand exactly what happened to the Liz Truss government. Not the politics, just the economics.

There were two main events. The first, around September 23, was the announcement of plans for a tax policy, including income tax cuts, to simulate economic growth. The second, exemplified by this NPR segment, was an obituary, signalling the end of a government and these policies. What happened?

I start with two points about the policy. First, there are many other instances in which governments use tax cuts to stimulate an economy. As usual there are issues of whose taxes are cut and for how long. All of this is important but relatively standard fare. It does not seem that the tax plan of Liz Truss was at odds with other such plans.

Second, it was only a plan. No taxes were actually cut. What we saw in the UK was a response in economic variables, such as the exchange rate and interest rates, to the announcement of a future policy change. This seems like further proof, as if any is really needed, that economic agents look to the future in making decisions today. They had some guidance through forecasts and analyses about what the effects of the policies might be once they were put in place. These had the potential to shape expectations and support the observed outcomes.

That is precisely what I want to talk about: the role of expectations in shaping the outcomes. The key is what individuals at the time of the policy think tax rates will be in the future when the fruits of their investment mature. So: what do people think will happen to taxes in the future if the government cuts taxes today?

Let’s go through the economics by going to some extremes. To make the experiment clear, suppose, as in the UK plan, there is a tax cut this year. The tax cut will lead to a higher deficit today and thus an increase in government debt outstanding. And imagine the plan is detailed enough that everyone knows for sure that the increased debt will be repaid, say, in 5 years.

Here is one way to think through the economic response. Suppose, and this is one extreme, everyone believes that the tax cuts will not lead to economic growth over the next 5 years. In that case, individuals should forecast higher tax rates in the future, needed to repay the increased debt associated with the tax cut. If so, the incentives to invest at the time of the tax cut will disappear in the face of expected higher future taxes. The tax cut will not induce growth. So the beliefs of no growth lead to exactly that outcome: the pessimism is self-fulfilling. In this case, we could see the type of response we saw in the UK, with higher interest rates and even an anticipation of future inflation if the Bank of England were to use monetary policy to monetize the increased debt.

There is another path, much more optimistic than the first. It is a growth path where individuals believe that the economy will grow in response to the tax cuts. In that case, the repayment of the debt in 5 years will not require higher tax rates. Instead the expanded tax base can finance repayment of the debt without an increase in tax rates. With this expectation of continued low taxes, individuals will invest and the economy will expand. The fiscal outcome 5 years down the road is consistent with their optimism and induces them to invest. In this case the optimism is self fulfilling.

Evidently there can be multiple, self-fulfilling paths. This argument can be formalized.

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It has two key ingredients. One is the response of investment to future taxes. The second is the idea that a future government liability can be financed either through: (i) low tax rates with a large tax base or (ii) high tax rates and a small tax base. Under optimism, it is the first option that drives the decision to invest and creates the large tax base. The second option is the pessimistic path.

When there is a policy announcement, as in the UK case, it is not clear which path the economy will take. In cases like this, it is not just what a government does but what it says about what it plans to do. Evidently, the talk was not very convincing in this case. The pessimistic path was selected.

1. See the papers by Jang-Ting Guo and co-authors for a sense of this literature.