UK should bring forward tax rises to fight inflation, IMF says

The IMF said on Tuesday that Rishi Sunak should bring forward planned tax increases to limit the risk of persistently high inflation, even though it would tighten the financial squeeze on Britain’s households.

In its annual assessment of the UK economy, the fund said the chancellor should spare poorer households and impose higher income and wealth taxes on richer people.

The IMF’s view is that wages and spending will not be squeezed as much as the Bank of England thinks, so there is a sizeable risk inflation stays too high for too long.

With inflation forecast to rise to 7 per cent in the coming months, the IMF warned that without higher taxes, the BoE would be forced to raise interest rates significantly, with a serious risk of tipping the economy into recession next year.

The fund said the BoE should continue raising interest rates steadily in the face of higher inflation to a “neutral setting” of between 1 per cent and 1.5 per cent. It said the rate hikes would not have much of an effect on spending or inflation until 2023, when growth would also be hit by planned corporate and income tax rises.

Mark Flanagan, UK mission chief at the IMF, told the Financial Times that the call to use higher taxes rather than higher interest rates to cool the economy was not something the fund “would recommend all the time”, but reflected the “specific circumstances” of the British economy.

The IMF said the big risk to the economy was for inflation to remain too high for too long and to become ingrained into UK price setting and wage demands, it said.

The report warned that wage settlements, corporate pricing intentions, survey and market-implied inflation expectations all “flashed red at present.”

Flanagan said the IMF expected wage and price growth to be stronger than the BoE and government had forecast. “We don’t see what will restrain wage settlements for the moment. There is still highly accommodative monetary policy, highly accommodative fiscal policy and the tightest labour market for some time. If I could write a recipe for strong wage growth, that’s it,” he added.

The fund said the best way to limit the risk of persistently high inflation was to bring tax rises forward, especially income or wealth taxes on richer people. This would also allow the government to spend more on reaching carbon neutrality and levelling up in future years when private spending growth was likely to be lower.

“The authorities could bring forward some fiscal tightening from 2023-24 to 2022-23 to help contain demand in the short run with the benefit of also reducing the drag on growth in outer years”, while using contingency funds to help the poorest, the IMF concluded.

Andrew Bailey, governor of the BoE, took a similar position on the threats of persistently high inflation. He told the House of Commons Treasury select committee there was “very clearly” a risk that high price rises and high wage increases could continue.

Economists in the UK were divided on the use of taxes to manage the swings in the economy, but generally thought the IMF’s concern about inflation was misplaced given the severe squeeze on incomes that households are facing this year.

Alfie Stirling, chief economist at the New Economics Foundation, praised the fund for being “much more open to using fiscal policy for managing the economic cycle”, but did not agree with the IMF’s assessment there was a serious excessive demand problem that needed higher taxes now.

James Smith, research director of the Resolution Foundation, said there were already big tax increases planned and with interest rates still very low, that was “another reason for monetary policy to do most of the tightening” to control inflation.

Jagjit Chadha, director of the National Institute of Economic and Social Research also thought higher interest rates would be sufficient to control inflation and that fiscal policy should be focused on “the broad assessment of taxes in the medium term”.

Shona Riach, who represents the Treasury on the IMF board, ignored the recommendation to bring forward tax increases in her formal response, while the account of the board meeting showed that “a few directors questioned the political feasibility of this suggestion”.