Mini-Budget: will Kwasi Kwarteng’s gamble on growth work?

What is “supply-side” economics?

Supply-side economics has two related meanings – one broad and one more specific. At its most general, the phrase “supply-side” simply relates to economic analyses that stress the importance of supply factors (as opposed to demand) in determining long-term growth. Such factors include the effect of incentives on production, the efficiency of the labour market, the need to avoid over-regulation and the level of saving.

More specifically, the term is associated with US and UK economic policy of the 1980s: so-called “Reaganomics”, shaped by economists such as Arthur Laffer, and Thatcherism. These doctrines’ emphasis on the supply side and individual choice marked a hugely influential break with the Keynesian consensus, with its focus on the demand-side and the role of public spending in stimulating the economy.

What did Reaganomics involve?

Its basic tenets were cutting taxes, especially for higher earners, reducing regulation, and tightening the money supply to control inflation. Like Thatcherism in the UK, the legacy of Reagonomics is strongly contested, since the period saw a welcome end to 1970s stagflation and higher growth, but also a rise in levels of inequality.

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The supply-siders contend that the key point is growing the economic pie, since this benefits everyone, rather than worrying about exactly how it is sliced up; the process of growth is inherently unequal as some benefit more than others. Governments can redistribute later; the point is to unleash enterprise, and cutting the tax burden is key.

Adherents of Reaganomics held that tax cuts need not be matched by expenditure cuts, because the tax cuts would stimulate enough growth to restore tax revenues. This belief (associated with the “Laffer curve”) is contested by most economists. The evidence suggests that major reductions in basic tax rates are not self-financing, but the approach is likely to work for cuts in higher-rate taxes.

What are Kwarteng’s plans?

The Truss-Kwarteng “unashamedly pro-growth” plan is explicitly “supply-side”, and involves the biggest net tax cut since 1972. The aim is to raise our GDP growth rate to 2.5%.

The package will reverse Rishi Sunak’s planned 1.25% national insurance rise; keep corporation tax at 19% rather than raise it to 25%; cut the basic rate of income tax by a penny to 19p; abolish the “additional” 45% rate on income over £150,000; and cut stamp-duty thresholds. Overall, it adds up to a loosening in fiscal policy, relative to the Johnson-Sunak government’s plans, of £44.8bn (1.8% of GDP) by 2026/2027, according to Capital Economics.

On deregulation, Kwarteng kicked off what he hopes will be a long-term process of “deregulation in the provision of all of energy, infrastructure, childcare, and housing”, says economist Ryan Bourne on Substack. For now, he announced new investment zones would be introduced, with greater tax reliefs and allowances, and easier planning processes.

In addition, he announced deregulation of housing planning and environmental reviews; reforms to agriculture and childcare; a lifting of the ban on bankers’ bonuses and fracking; and investment in new onshore wind generators. He is also reforming the IR35 payroll rules for contract workers.

Will it work?

Short-term market reaction to last Friday’s budget (styled as a “fiscal event” to let Kwarteng avoid publishing analysis by the Office for Budget Responsibility) was catastrophic. Sterling slid and gilt yields (government borrowing costs) soared, pushing up mortgages. On Wednesday the Bank of England was forced to intervene in the gilts market.

The problem is that, whereas Margaret Thatcher was a fiscal hawk, the Truss-Kwarteng package is fiscally incontinent and uncosted, says Ambrose Evans-Pritchard in The Daily Telegraph. Markets were concerned the package would just fuel debt and inflation further.

A key problem is that there seems less scope for a supply-side boost than in the early 1980s. In 1981, US public debt was at a century-low of 31% of GDP. Our overall debt pile is around 85%. “You cannot do Thatcherism twice,” says David Smith in The Sunday Times. Thatcher slashed the top rate of tax from 83% and the basic rate from 33p. By comparison, a penny off the basic rate and a 5p reduction in the top rate look small beer.

Have markets overreacted?

The UK government could have “made its job a bit easier” by recognising that Britain is not the US, and offering “much more clarity on how debt would be managed in the longer term”, says Substack’s Bourne. But even so, the market panic has been wildly overblown given that a genuine currency crisis is not on the cards: the UK does not try to manage its exchange rate, and doesn’t have significant debts in foreign currencies.

The problem, says The Daily Telegraph, is that “many observers – including left-leaning economists in the US, in financial institutions and international bureaucracies – don’t understand what Kwarteng is trying to do”. That is, to tear up the “redistributive consensus” and promote genuine, pro-enterprise, supply-side reforms. Of course, the “Growth Plan will only succeed if it is the beginning of a long-term strategy”, but the government fully understands this – and more is coming.

So will the reforms boost growth?

There seems likely to be a short-term boost to growth from the measures, although higher long-term interest rates due to bond yields rising (and a rise in short-term ones later if the package is inflationary) will have a braking effect.

But as far as lifting our potential growth rate goes, it may not make a big difference, says Ruth Gregory of Capital Economics: for now, at least, “the chancellor’s really bold ambitions on the supply side remain only that”.