What tumbling inflation means for Hunt’s hopes of tax cuts

Falling inflation has handed Jeremy Hunt a boost less than a week before he delivers his second Autumn Statement.

The Chancellor’s latest assessment of the economy will be delivered against a different economic backdrop to a year ago. Growth may still be elusive, but inflation is now falling sharply, not rising.

Prices, as measured by the consumer prices index, rose by 4.6pc in the year to October, down from 6.7pc in September.

With signs that the worst of the cost of living squeeze is over, inflation at a two-year low and interest rates expected to fall next year, there is now speculation that Hunt will announce tax cuts next week.

Can Hunt cut taxes?

In theory, the Chancellor can tax and spend as he pleases.

In practice, Hunt, who was brought in by former prime minister Liz Truss on a platform of fiscal rectitude, will stick to self-imposed tax and spending rules requiring him to get debt falling in five years time.

The Office for Budget Responsibility (OBR) is the tax and spending watchdog that determines whether he meets this pledge, limiting his room for manoeuvre on tax cuts.

The good news is that tax revenues are booming thanks to stealth levies on British workers.

The Institute for Fiscal Studies (IFS) estimates that a six-year freeze in income tax thresholds is the equivalent of a 6p increase in income tax.

This will see the Treasury rake in an extra £52bn a year in so-called fiscal drag by 2027, according to the think tank, which will see the number of people paying the higher or top rate of tax double to 8.9 million in a decade.

With inflation finally falling, this will help the Government deal with a debt interest bill that is expected to climb to £94bn this tax year alone. It also puts less pressure on Whitehall budgets, which are set in cash terms.

Taking all this into account, the Resolution Foundation believes this has left Hunt with around £13bn of headroom to play with, double what he had in the spring.

It’s also worth noting that while the bigger-than-expected drop in inflation is welcome, it comes too late for it to influence the OBR’s baseline assessment of the economy.

The ink has already dried on its assumptions on interest rates and other borrowing costs, which were taken over the ten working days to October 11 and sent to the Chancellor on October 31.

This assumed benchmark 10-year borrowing costs of around 4.5pc.

This was before Bank of England chief economist Huw Pill sparked a downward lurch in borrowing costs and a mortgage price war by suggesting interest rates could fall next summer. 

Ten-year gilt yields are currently closer to 4.1pc as a result, which will reduce the debt interest bill and put government budgets under less strain. With debt currently running at £2 trillion, small movements in interest rates make a big difference.

While the OBR forecast has closed, a Treasury insider said much of the fall in inflation had already been “accounted for” in its forecasts.

Will Hunt cut taxes?

Probably, but tax cuts will be targeted and in some cases temporary. Hunt made it clear last week that any cuts that stoke inflation are off the table as they focus on the last mile of getting the rate of price growth back down to the Bank of England’s 2pc target.

Hunt has made no secret of the fact that he would like to make his flagship business tax cut permanent but has so far ruled out any personal tax breaks that fuel inflation. So-called full expensing allows companies to write-off the cost of investment against their tax bill in one go, allowing them to shave up to 25p off their tax bill for every pound invested.

The OBR believes making it permanent costs £10bn a year, though the Treasury has been consulting the IFS and Centre for Policy Studies (CPS) who both believe the long-term cost is much less. It is likely that the policy will be extended for at least a year, as it is considered not to be inflationary.

“Inheritance tax would be another way to cut taxes,” said Martin Beck, chief economic adviser to the EY ITEM Club. “It would not be inflationary,” he added, noting that most of the extra cash being inherited would likely be saved instead of spent, and so not add to price pressures.

The IFS calculates that keeping the share of estates that pay the tax at the long-run average of 4pc would require the tax-free threshold to be raised from £325,000 to £380,000 at a cost of £900m a year.

Should he cut taxes?

Tory backbenchers have been calling on Hunt to cut levies since he took office last year through targeted measures to stimulate an economy that is flatlining.

Earlier this week, a taskforce set up by Truss warned Britain was facing two decades of lost growth because Hunt had failed to incentivise work by piling taxes on families.

The Growth Commission said the current Chancellor had pushed the economy into a low growth trap, with GDP per head expected to grow by just 1pc annually over the next 20 years.

The influential Conservative Growth group are pushing Hunt to raise the VAT threshold for small businesses, cut stamp duty for main homes and to set out a path to raise the inheritance tax threshold to £1m.

When will he cut taxes?

Beck cautioned that the Bank of England will act against any perceived inflationary pressures, counteracting tax cuts by keeping interest rates high.

“He has a little more headroom, but it is problematic as long as the Bank of England retains its macho posturing and is pessimistic [on growth], it delays rate cuts if he does anything big on the fiscal side,” Mr Beck said.

“If the Government were to loosen fiscal policy, the Bank would presumably respond by keeping monetary policy tighter than otherwise – it might not cut rates as soon. They are still constrained by the Bank’s pessimistic view.”

Despite concerns that the economy could be in recession early next year, which could make tax cuts harder, Beck said Hunt may have more money to play with in the Spring.

“If he waits, he will probably have a better economy in March and inflation will come down faster than the Bank anticipates, as it has been doing, and will have to rein back their pessimism.”