Rachel Reeves is fast discovering the limits of how much money she can extract from the economy without raising ‘taxes on working people’.
Let’s review the numbers. The Labour manifesto had £7.35 billion in revenue raising initiatives (in fiscal year 2028-29), with most coming from non-doms changes (£5.23bn), VAT on schools (£1.51bn), and carried interest (£0.565bn). Then they had spending commitments of £4.84bn. So about £2.5bn left over. But Rachel Reeves also must find large sums of money to fill her fiscal black hole of £20bn.
She’s vowed to fill it with a combination of tax rises and spending cuts. But on the tax side, her options are limited, with the Government having already ruled out changes to VAT, income tax and national insurance.
Furthermore, it’s reported that she has ruled out reducing pensions tax relief for higher earners, due to the effect it would have on public sector workers.
That’s not all – even the tax changes listed in their manifesto have run into problems. Reeves has been warned about changes to carried interest – that it will drive away asset management clients. Changes to non-dom rules are being reconsidered, as Treasury officials fear that tightening rules further would actually lose the Government money. There have even been rumours of delays to VAT on school fees being implemented on January 1, with fears about the effects it could have on schools and teachers.
Other changes have been mooted, like raising capital gains tax, but many of these suffer from the same problem. If taxes are a certainty of life, then it’s also a certainty that people will try to avoid them. All taxes can change behaviour, but taxes on capital and wealth change behaviour more. For the very wealthy, tax rises are relatively easy to avoid if you can leave a country or pay lawyers to minimise a tax liability. The fact is that there’s only so hard you can squeeze the rich before they leave or find ways to avoid tax. The Institute for Fiscal Studies has produced a list of changes that could be made, but none on their own raise more than £3.5 billion.
That leaves Rachel Reeves in a bind, and she has four options. Firstly, she can throw the kitchen sink at the problem, raising a little here and a little there, to try to plug the gap – which is more or less what she’s been trying to do already. The problem is that many of these changes are economically distortive and will act as anchors on growth.
Secondly, she can find ways to cut spending. However, if it’s to be politically popular, she is likely to cut capital spending, which could undermine future public sector productivity growth, necessitating still more taxes to fill the holes down the road.
Thirdly, she can borrow more and change the fiscal rules.
Or fourthly, she can abandon the election pledge and raise tax via income tax, national insurance or VAT.
There are likely to be more fiscal challenges in the next five years. And Reeves will need to make hard choices. That’s because, fundamentally, if the state is going to grow as a share of the economy, it will almost certainly require more taxes on working people. Governments that spend more money tax workers more. This implies a pretty stark fiscal choice for the UK. Be more like Europe, with higher spending and higher taxes on working people, or have lower taxes but find ways to cut spending.
Tax burden on labour vs Government spending, OECD
The tax burden is the percentage of employer’s cost of an employee that is taxed, including VAT and taxes on income. It is based on a single worker with no children on average wage.
Source: Tax Foundation, IMF
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However, there is a greater issue at stake here. The UK is sorely lacking a long-term fiscal strategy and vision (and the Conservatives are guilty here as well). Decisions on tax and spend have been marginal decisions that seek to see debt falling as a percentage of GDP in five years’ time. Labour seems intent on doing the same, with the hope that productivity growth will make all our problems go away.
To a very large extent, productivity growth is needed to solve our fiscal challenges. But without clear long term fiscal goals on government spending and taxation, we risk stumbling our way to a larger and larger state. We have sleepwalked into the highest tax burden in over seventy years, a distortive tax system, inefficient government services, and entitlement spending that is set to drastically rise. Chancellors need to stop seeing the budget as a political game or setting arbitrary traps for themselves. Instead, the Chancellor (and the Conservative shadow chancellor) need to set out their plan for tax reform and a vision for what the state should and shouldn’t do. This should be central to Labour’s mission for economic growth – if they (or the Conservatives) are serious about fiscal sustainability and productivity, they need to articulate a clear fiscal strategy.
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