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Tax cuts in doubt amid high inflation and strained public finances

·Business Reporter, Yahoo Finance UK
·3-min read
Rishi Sunak and Liz Truss are in an arms race over tax cuts
Rishi Sunak and Liz Truss, in the race to be the next prime minister, are in an arms race over tax cuts in an effort to convince Conservative party members they are the right candidate for the job. Photo: Jacob King/Pool via Reuters

The promise of large permanent tax cuts has been thrown into question amid soaring inflation and a deteriorating outlook for public finances.

According to the Institute for Fiscal Studies (IFS), runaway inflation will instead mean more spending on social security benefits, state pensions and debt interest.

Over the next two years it is expected to more than offset the additional tax revenues generated by high inflation in spite of lower growth.

“As a result, the forecasts accompanying the forthcoming autumn budget are likely to show the near-term public finances in a weaker position than forecast by the Office for Budget Responsibility (OBR) back in March,” the IFS said.

This is before any tax cuts, other additional support for households, or extra money for public services that are also struggling with rising prices.

Read more: Rishi Sunak vows to cut income tax to 16%

It comes as the Rishi Sunak and Liz Truss, in the race to be the next prime minister, are in an arms race over tax cuts in an effort to convince Conservative party members they are the right candidate for the job.

“The two candidates for prime minister also need to recognise the even greater than usual uncertainty in the public finances. Additional borrowing in the short term is not necessarily problematic — and indeed may be appropriate to fund targeted support," the IFS added.

“But large permanent tax cuts would exacerbate already substantial pressures on the public finances — as spelled out by the OBR only last month — unless matching spending cuts can be delivered.

“In reality significant spending increases are likely to be needed in face of high inflation.”

The research from the IFS is an early output from the 2022 IFS Green Budget report produced in association with Citi (C) and funded by the Nuffield Foundation. Its central projections for next year use the Bank of England’s (BoE) new forecasts for inflation and growth.

In 2023–24 borrowing is forecast to increase by £23bn, simply through additional spending on social security benefits and state pensions (up £4bn on current forecasts to £275bn), and debt interest (up £54bn to £104bn), only partially offset by higher revenues, which are up £34bn.

Read more: Sunak and Truss's tax plans: What Tory leadership result will mean for your income

The IFS warned that there will be additional pressures, likely running into tens of billions, to continue to support households and to compensate public services for high inflation.

If inflation falls back to normal levels by 2024–25, then debt interest spending will fall.

Higher tax revenues and increased spending on benefits and pensions could largely offset one another by then, leaving borrowing broadly in line with the OBR’s March forecast.

However, pressures on public services will be more acute, and higher spending than planned seems very likely. The uncertainty around tax revenues will depend on the length, depth and pattern of any period of economic weakness.

Carl Emmerson, deputy director of the Institute for Fiscal Studies and an author of the report, said: “The reality is that the UK has got poorer over the last year. That makes tax and spending decisions all the more difficult.

"It is hard to square the promises that both Truss and Sunak are making to cut taxes over the medium-term with the absence of any specific measures to cut public spending and a presumed desire to manage the nation’s finances responsibly.”

Watch: How does inflation affect interest rates?