Meanwhile, in the United Kingdom….

The UK Conservative Party has replaced Boris Johnson with Liz Truss. The new Prime Minister and her Chancellor of the Exchequer (Kwasi Kwarteng) wasted little time making dramatic shifts to the nation’s economic policy. Reaction has been … mixed (Telegraph).

The pound plunged to a fresh 37-year low of less than $1.09, while UK borrowing costs suffered their biggest one-day jump on record after Mr Kwarteng announced a £45bn package of unfunded tax cuts that economists described as a “high-risk leap of faith”.

Mr Kwarteng said the tax burden was “forecast to reach the highest levels since the late 1940s – before even Her Late Majesty acceded to the throne”. He said: “We need a new approach for a new era, focused on growth.”

In a decisive break with his predecessors, Mr Kwarteng cut income tax, National Insurance and stamp duty in the hope of keeping Britain out of recession and boosting competitiveness. Analysts warned it would add hundreds of billions of pounds of increasingly expensive borrowing.

Since then, the British pound has fallen as low as $1.03.

The plan has its defenders – in the very same paper – but even they bring caveats.

In one bound, the Tories have transformed themselves from the fiscal conservatism of the Cameron/Osborne era into a Reaganite show of fiscal incontinence and Thatcherite derring-do economic reform.

But it was also a breath of fresh air after the fiscally constipated Budgets that have ruled ever since the financial crisis – high political and economic risk, no doubt, but a seemingly determined attempt to get the economy out of what Kwasi Kwarteng, the Chancellor, called “a vicious cycle of stagnation” by unashamedly putting wealth-creating enterprise back centre stage.

The Budget deficit is going to remain at well above £100bn for at least the next three years.

Nor in themselves will these tax cuts generate the 2.5pc per annum growth the Government is banking on to pay for it all. Unbacked by the sort of additional supply side reforms to planning, immigration the many other barriers to enterprise Kwarteng referred to in his speech, it won’t work, and will merely end up busting the public finances.

It is not yet clear the Government has the resolve or the mandate for the sort of reforms it speaks of. Many have tried before, and failed. There was also alarmingly little mention in the Government’s plan for growth of spending cuts to help offset the tax-cutting zeal. But this is undoubtedly an encouraging start.

Indeed, much of the supply-side reforms promised were vague, save for the income tax reduction. That last bit plus the other tax cuts have spooked markets into seeing higher deficits and higher inflation. Time will tell who is right.

If Truss and Kwarteng do manage “the resolve” for those reforms, Britain could well see an economic renaissance. I fear, however, that they’ve taken the wrong lessons from the Reagan era on taxes. Contrary to the assertion of his critics, Reagan’s tax policies did indeed change over time. The tax plan in his second term (1986) was very different from his first (1981) – and Truss may have picked the wrong one.

Income Tax Reduction versus Income Tax Reform

The Reagan tax cut of 1981 is clearly the model for Truss 2022. It had the advantage of being a straightforward reduction in taxes without the bizarre ornaments that came with the Trump tax cut of 2017. However, it made no attempt to address the resulting spike in aggregate demand that would come from higher deficits.

At the time, supply-side theory held that the improvement to aggregate supply would address the demand spike, while the resulting economic growth would bring the deficit back down. Keynesian economists disagreed – and much of Wall Street did too. The Federal Reserve reacted to all of this with a firm hand and a refusal to loosen monetary policy. Growth did come, but only after the longest and deepest recession between 1941 and 2008.

Reagan’s second term saw another dramatic reduction in income tax rates. In fact, the highest income tax rate fell further in 1986 (from 50% to 28%) than it had in 1981 (from 70% to 50%). The surrounding political and economic environment were very different, however. Rather than a tax cut, Reagan proposed a tax shift. The rate reductions would be equaled by eliminating loopholes and carve-outs in the tax code.

The result was a simpler code, far less economic activity being wasted on tax avoidance, and less concern about income distribution (as the wealthy were the ones most likely to take advantage of the loopholes). In part for that reason, Democrats joined Republicans in supporting the reform.

Moreover, the supply-side boost that came from a simpler code and lower rates did not have an inflationary demand spike. As a result, the recovery of the 1980s ran into 1990, becoming the longest recovery in history up to that time. Inflation remained slow; and even income inequality leveled off for roughly four years.

The tax reduction proposed by the UK government is clearly closer to Reagan 1981 than Reagan 1986. History, however, tells us that the 1986 reform was a more successful – and certainly less painful – growth policy.

Then There’s the Rest of the Story

Meanwhile, Truss and Kwarteng made no mention of spending reductions, which would have gone a long way to alleviating the concerns of the markets. Kwarteng has since promised to “set out a plan to cut the UK’s debt on November 23” (Telegraph).


Building on this, as the Growth Plan set out on Friday, Cabinet Ministers will announce further supply-side growth measures in October and early November, including changes to the planning system, business regulations, childcare, immigration, agricultural productivity, and digital infrastructure.

We’ll see what those measures are, but as I noted when Virginia went on a tax-cutting spree:

The above measures will put more money in more pockets, but in the process they will also make everything that money can buy more expensive.

This is exactly what Truss and Kwarteng should hope to avoid.

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