Could UK’s destabilizing tax cuts offer lesson for Korea?

Posted on : 2022-09-28 17:24 KST Modified on : 2022-09-28 17:24 KST
In both Korea and the UK, the new administrations have introduced massive tax cuts and are attempting to increase supply through corporate tax breaks and deregulation in response to inflation
Londoners walk past a downtown money exchange on Sept. 26. (AP/Yonhap)
Londoners walk past a downtown money exchange on Sept. 26. (AP/Yonhap)

“Bad move.” “Self-inflicted wound.” “House built on the sand.”

These are the titles of reports pouring out of Korean securities companies following the announcement of large-scale tax cuts by the British government. These massive cuts have been a double whammy for the UK in terms of bonds and its currency, causing global financial markets to fluctuate during a time of high inflation and high interest rates.

Former US Treasury Secretary Larry Summers, who has warned of the risk of high inflation globally, said that “Britain will be remembered for having pursued the worst macroeconomic policies of any major country in a long time.” Some have pointed out that the Korean government, which is pursuing tax cuts that resemble those of the UK, needs to consider revising its policy.

On Monday, the UK’s two-year gilt yields in the UK bond market closed at 4.53%, up 0.62 percentage points from the previous trading day. The yield on the two-year gilt, which is sensitive to changes in the Bank of England’s policy interest rates, has jumped more than 50% in about a month from about 3% at the end of August. In other words, a so-called “gilt tantrum” has occurred.

This is the result of the economic stimulus measures announced by the British government on Friday. The core of the stimulus plan is to provide households and companies with 60 billion pounds worth of subsidies for gas and electricity bills over the next six months, in addition to a 45-billion-pound tax cut, the largest in 50 years. This can be seen as a bold move by Prime Minister Liz Truss, who took office earlier this month, to lower the burden of high prices and boost the real economic growth rate, which is expected to be 0% next year, to 2.5%.

The problem is that government bonds will have to be issued on a large scale to cover insufficient tax revenues. Concerns over the increase in the supply of bonds, as well as fears that the return on investment in British government bonds will be sluggish amid a strong US dollar, have led to the dumping of British government bonds in the market and soaring yields on the bonds. In addition, there are concerns that increasing market demand through stimulus measures such as tax cuts could actually lead to further price increases and speed up policy rate hikes.

That the pound plunged to an all-time low along with the price of British government bonds can be seen as the result of falling confidence in the British government’s economic policy by the financial market. Usually, when the policy interest rate rises, the value of the currency should rise alongside it as investors seek more interest, but in this case, the opposite is occurring. The tax cuts may fail to achieve both price stability and growth while increasing government debt because of high interest rates, causing problems for the national credit rating. Olivier Blanchard, former chief economist at the International Monetary Fund, recently wrote on his Twitter account, "We are lucky that the UK is not in the euro. Otherwise, we would be facing another euro crisis."

The tax cuts carried out by the British government mirror those of the Korean government. The logic is the same as well in that both administrations, upon taking over, have introduced large-scale tax cuts and are attempting to increase supply through corporate tax reduction and deregulation in response to inflation.

Controversy over “tax cuts for the rich” and “trickle-down economics” stemming from corporate tax, income tax, and real estate tax cuts has also arisen in both the UK and Korea. However, in a Financial Times column, Martin Wolf asserted, "If the supply side promises are a fantasy, the fiscal and economic risks are not." In other words, the effects of the tax cuts on expanding supply are unclear, but there is a real risk that they may cause macroeconomic instability given the current high level of inflation.

Of course, there are also differences between the UK and Korea. The UK government’s debt-to-GDP ratio stood at 102.6% in 2020, more than double that of Korea (48.9%). And while Korea maintains a surplus in its current account (i.e., the total savings and investment of the country) with the help of its export manufacturing industry, the UK suffers from a chronic current account deficit and is vulnerable to energy crises. “Recently, external issues have grown much more influential that the market is more sensitive to the policies of individual countries than in the past,” said an official from the Ministry of Economy and Finance.

“The basic situation [between the UK and Korea] is different in that while the UK has been running up a huge fiscal deficit due to tax cuts and increased spending, which caused a massive issuance of government bonds, Korea’s fiscal balance (income-expenditure) has improved through a reduction in spending compared to the COVID-19 period.”

By Park Jong-o, staff reporter

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