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Chancellor Kwasi Kwarteng's tax cut bonanza fails to work magic on markets

Chancellor Kwasi Kwarteng's tax cut bonanza fails to work magic on markets

While implementing dazzling spending commitments at the start of the pandemic, Rishi Sunak vowed to do whatever it takes.

Two and a half years after Russia’s war in Ukraine and rising global inflation have pushed another foreign minister, Kwasi Kwarteng, to unleash a new fiscal tidal wave.

But the approach to paying for it is very different. And that has set off alarm bells in the markets, with the pound and UK bonds plummeting. One expert even said an emergency rate hike from the Bank of England next week might be needed to try to stop the slide.

Kwarteng is betting that big tax cuts and a bonfire of regulations will spur investment, boost growth and benefit the entire economy.

“This is how we will successfully compete with the dynamic economies around the world,” he said. ‘This is how we will turn the vicious circle of stagnation into a virtuous circle of growth.’

Sunak’s language after his extensive speech was quite different.

It spent £376bn to tackle the pandemic and its crippling effect on the UK economy. It was followed by the energy crisis and a £37bn cost-of-living support package.

But Sunak was quick to warn that tough decisions would need to be made to deal with the massive amount of debt of more than £2 trillion that had accumulated. “We can’t spend money we don’t have,” he said.

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That led to a much-criticized national insurance raid on workers and employers, and the highest tax burden in 70 years.

Kwarteng not only reversed that decision, but also scrapped plans to raise the corporate tax rate, raised the stamp duty threshold and slashed income tax.

The cuts will represent a £44.8bn annual hit to public finances for 2026-27, the biggest tax handout in half a century.

Added to that is a commitment to freeze energy bills for two years, at an estimated cost of £60bn over the next six months alone. The total cost could be around £100bn, independent experts say. Kwarteng said it was “totally appropriate”, comparing it to action during the pandemic.

“A considerable intervention was then and it is now,” he said.

HSBC economists said that over the next two years the package was “approaching the scale of what was delivered in the pandemic”. But “the context in terms of monetary conditions could not be more different,” they noted.

In 2020, interest rates were 0.1 percent. Today, with inflation at a four-decade high, rates are on the rise, reaching 2.25 percent this week, the highest level since the financial crisis.

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The pound, already on the ropes after 12 rounds with the mighty dollar, was positively intoxicated after Kwarteng’s announcement, falling to a new 37-year low below $1.09.

UK bonds, packages of government debt, also sold off strongly. Five-year bond yields saw their biggest one-day rise in 31 years. Higher yields translate into higher borrowing costs for the Treasury.

And it will take much more. The Institute for Fiscal Studies predicts £190 billion, or 7.5 per cent of GDP, in this fiscal year, second only to the post-war period by the financial crisis and the pandemic.

Director Paul Johnson said: “The early signs are that the markets, which will have to lend the money needed to close the gap in the government’s fiscal plans, are not impressed.” George Saravelos, head of currency research at Deutsche Bank, warned that “the pound is in danger” as investor confidence in the UK’s external sustainability is rapidly eroding.

Preventing the pound from weakening could mean that sharp interest rate hikes are needed outside of the regular cycle of monetary policy committee meetings. Saravelos said: “The required policy response is clear: a big intersessional rate hike by the Bank of England as soon as next week to regain credibility with the market.”

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The Treasury estimates that the Kwarteng cuts will boost the economy and ultimately generate additional revenue, without estimating how much. It calculates that if 1 per cent is added to expected GDP growth each year for the next five years, revenue would be £47bn higher over five years, roughly equivalent to the impact of the planned tax cuts, despite skepticism. that such growth will occur.

There was a wide reception from business groups. Kitty Ussher, from the Institute of Directors and a former Labor Minister, said: ‘This is a day of good news for British business. At a time of low confidence and economic uncertainty, the emphasis on seeking growth will be welcomed by companies of all sizes.’

But he expressed concern that the independent Office for Budget Responsibility had not applied the rule on numbers.

“Without this, neither business nor Parliament have any assurance that the scale of this intervention is affordable,” he said.

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