In today’s issue:

  • It’s government spending that defines us
  • Taxation or inflation – take your pick
  • Argentina has woken up

Did you notice the “budget black hole” was always about a lack of tax revenue and never about too much spending?

The question was always which taxes can be raised and never which spending should be cut.

It makes me glad my wife is a frugal sort.

Imagine being married to a Labour politician.

By the time you read this, Chancellor Rachel Reeves will have “handed down” her budget. An ironic choice of words given that it’s full of tax increases.

The entire country is in a fervour over who will be paying how much of more. What the government is actually doing with the money isn’t getting much attention. Apart from a few hilarious examples coming out of gender studies research grants.

The tax side is getting all the coverage. There’s the private school fee VAT story. Inheritance tax changes. Capital gains tax adjustments. National insurance shuffles. The domicile of non-doms. And plenty more…

But what if it’s all for show? A distraction to avoid debating what really matters…

The spending.

It sounds like some sort of chicken and egg problem. But isn’t. Government spending matters a lot more than the taxes that fund it. Exploring why will show you just how bad a mess we’re really in…

Spending is all that matters

Firstly, it’s only because the government spends money that we need to tax. A government with little spending needs only small amounts of taxes. And at lower rates of tax, taxation is far less controversial.

The drama over this years’ taxes is playing out because government spending is so high that taxes must be high too. At almost half our GDP, the government parasite is at risk of killing its taxpaying host.

Of course, if people got good value for money on government spending, they might be happier paying more taxes. But the drama over taxing private school fees is a good example of what actually happens.

The government provides a substandard service and so people take matters into their own hands. Taxing such people is bizarre. They pay taxes to fund government schools for someone else’s children. They pay fees to fund their own children’s schooling. And now they pay tax on those fees too!

The same goes for private healthcare and many other sectors of the economy where government services are so bad there’s a parallel private sector.

People are angry to pay taxes for something that is so substandard they have to go elsewhere. Adding taxes to their attempts to escape substandard services is adding insult to injury.

The second reason that government spending matters more than taxes is a little less obvious. Not all government spending need be financed through taxes. The government can create an illusion of temporary prosperity by spending more than it takes in.

You might say this must eventually be paid for, with even more taxes. But that’s not necessarily true. The government could always print the money it spends.

This causes inflation. But, as Milton Friedman put it, inflation is taxation without legislation.

The premise of this quote is that the government can devalue the money it borrowed by creating inflation. Devalued money makes it easier to pay back debt. And nobody is indebted like governments.

Inflation also pushes people into higher tax brackets. The Telegraph is reporting on this:

The number of jobs paying a higher rate salary has doubled in three years amid a stealth tax raid on incomes, figures reveal.

Lecturers and paramedics have been dragged into the 40pc band that has historically been applied to wealthier professionals.

The freeze on tax thresholds, which Rachel Reeves is set to extend in her Budget, means middle-income earners are falling into Britain’s second-highest tax bracket.

One in ten occupations across England and Wales now has a median salary of more than £50,270, compared with just one in 20 three years ago.

So, inflation has worked precisely as intended. It just wasn’t enough to cover an increase in spending.

Few people realise that inflation is a tax. They don’t connect the higher prices they pay with any sort of benefit to the government’s balance sheet. If they did, and people realised inflation is a deliberate policy by government to “repay” its debts, they’d be rather angry about it. And they might even demand spending cuts instead of inflation.

The third reason spending matters more than tax is a little more ideological on my part. The overall level of government spending also measures the level of government intervention in the economy. This removes resources from the private sector, where they would’ve been used more productively. And so we get less economic growth in countries with more government spending.

Every public sector worker demanding we pay their wages in taxes is a potential private sector worker who could be paying taxes. Shuffling them around has a big impact.

Government’s negative impact on GDP growth is only true over longer periods of time, of course. In the short run, government spending can goose GDP. That’s playing out right now in places like the US and Australia. The latter is seeing a jobs boom driven almost entirely by the public sector.

But in Europe, we see the consequences of the policy over the long run. Such low economic growth that taxes must be very high as a result. Growth no longer makes it a matter of time before we can afford high government spending by growing the tax base.

Speaking of maxed out, the fourth reason tax increases don’t matter much anymore is that they don’t seem to raise much more revenue, if any. The taxpayers are taxed out. They’ll leave, earn less or hide.

If Reeves’ taxes really do fail to raise more revenue, as some modelling suggests, that implies more tax increases won’t happen in the future. Leaving only government spending as the lever to pull if the deficit is too large.

We could be on the cusp of the other half of austerity – spending. And that’d actually work.

The final reason Reeves’ taxes don’t matter is that they have no hope of covering government spending anyway. This chart from the Office for Budget Responsibility makes it painfully obvious that spending is the issue. While taxes are projected to fall over time, spending is going parabolic. The deficit is going to persist, until some sort of crisis.

The only way of solving that crisis is cutting spending, radically. The real question is how bad the fiscal crisis must get before we accept this.

In Argentina, things needed to get pretty damn bad before the electorate woke up. But they have realised that it is government spending that’s the key. And elected Javier Milei to take the chainsaw to that spending.

Will we wake up before things get as bad in the UK?

To sum up, whether you pay for it through inflation or taxation, it’s government spending that drives either painful policy. So, only by cutting spending radically can the two scourges be reduced to more acceptable levels.

Last night, I had drinks with a friend of Argentina’s President Javier Milei in Barcelona. He’s the fifth person who has confirmed to me that the rather passionate economist turned politician is the real deal.

I wonder if he’ll inspire a new generation of politicians to fire up their own chainsaws. Quite frankly, there’s only one politician in the UK who might actually do it.

What’s noticeable is how poor the investment outlook is, regardless of what happens. Financial markets have been inflated on the back of unsustainable government spending for decades. Any genuine spending cuts would undermine returns. It’s time to get defensive. Here’s how.

Until next time,

Nick Hubble
Editor, Fortune & Freedom