Leading market analysts have warned that tax cuts proposed by many Conservative leadership hopefuls could lead to greater monetary tightening from the Bank of England.
Consumers might therefore find that any extra cash they get in their pockets from a tax windfall "is swallowed up by higher mortgage and loan payments", AJ Bell said, describing such a move as "robbing Peter to pay Peter".
Rishi Sunak, the former Chancellor who presided over much of the increase and is now running to be leader, has suggested that promises to reduce income or corporation taxes are a “fairytale” at a time when the public finances are under severe pressure.
Tax pledges in the leadership race include Penny Mordaunt’s offer to cut VAT on fuel and to raise income tax thresholds. Liz Truss has promised to reverse April’s national insurance raid and cut corporation tax. Suella Braverman has said “radical tax cuts” will themselves help tackle the cost of living crisis.
Laith Khalaf, head of investment analysis at AJ Bell, said the Bank of England "will be watching very closely" as the race unfolds.
"Fiscal policy is a key input into monetary policy decisions, and while the Bank of England is desperately trying to pour cold water on inflationary pressures, sweeping tax cuts could set them alight again," he said.
“Tax cuts taken in isolation are clearly positive for today’s consumers, but in the current inflationary climate, any fiscal easing from the government could simply lead to greater monetary tightening from the Bank of England.
"Consumers might therefore find that any extra cash they get in their pockets from a tax windfall is swallowed up by higher mortgage and loan payments. The combined effect could be a bit like robbing Peter simply to pay Peter."
Mr Khalaf said the basic rate of income tax is "a particularly sticky lever" to tamper with because it becomes politically challenging to move it in the opposite direction again once the rate is cut.
The last time the main basic rate of income tax was raised in the UK was in 1975, when the Chancellor at the time, Denis Healey, increased the rate from 33% to 35%. He referred to it as an ‘anti-inflation surcharge’, viewing it as a necessary step to curb wage inflation.
Mr Khalaf added: "If the next Prime Minister does press ahead with a cut to the basic rate of income tax and that subsequently results in higher inflation, the risk is they then lack the political capital to backtrack, leaving the Bank of England to play bad cop by hiking interest rates instead.
“A cut to VAT would, on the face of it, have a one-off dampening effect on inflation. Although that would ultimately be reversed if the cut was only temporary, and it could eventually exert upward pressure on inflation over the longer term by encouraging consumer spending.
"Likewise, cutting corporation tax would put more money in the pockets of businesses, allowing them to pay more to workers in an already incredibly tight labour market. This risks a wage-price spiral taking off, deepening the inflationary bind the country finds itself in and requiring further intervention from the Bank of England."
However, the next prime minister will have room to cut taxes without stoking inflation, Britain's fiscal watchdog has said, in a boost for leadership candidates who have pledged to reduce the burden on private industry.
Tax cuts are less likely to drive prices higher because an economic slowdown appears to be taking hold, according to David Miles, a member of the Budget Responsibility Committee and a former Bank of England interest rate setter.
Speaking to MPs on the Treasury Select Committee, he said: “There are some indications, on forward-looking consumer sentiment and investment sentiment indicators, that the economy might be slowing.
“So it could be that tax cuts, to the extent that they increase spending, come at a time when things are slowing down anyway and therefore that would have less of an effect on creating inflationary pressures.”
FTSE 100
The UK's top share index, the FTSE 100, was down 20 points shortly after opening this morning, following yesterday's 53 point fall.
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