Labour's new tax bombshell

<em>The 2nd Term</em> - Within just a few weeks, ministers may come to regret one crucial election p

Why did Labour promise not to raise income tax rates during the coming parliament? As soon as it ruled out one kind of tax increase, it laid itself open to questions about why it wouldn't make the same pledge on other taxes. The Tories focused on national insurance, claiming that Labour would abolish the ceiling on employee contributions, thus creating a 50 per cent top rate of tax on income. Gordon Brown was forced to issue a denial (though he avoided a promise not to raise the ceiling). So a second tax pledge was created under duress.

Like generals planning to fight the last war, Labour strategists thought the income tax pledge would shore up Middle Britain's support, as they believed it had in 1997. But the public has moved on. People now know how easy it is to raise taxes in ways other than through income tax rates. More important, they are no longer hostile to the idea of "tax and spend". Last time round, Labour boasted of its low spending commitments; now the party has won a mandate on an explicit promise of higher public expenditure.

But though the terrain of political conflict has moved significantly leftwards, half of Labour's army remains on the old battleground. Even in the most propitious electoral circumstances imaginable, the Prime Minister and the Chancellor have been unwilling to talk about the tax half of tax and spend. It has been left to the Liberal Democrats to make the basic social-democratic case that if the British want better public services, taxes are the price they must pay.

This whole question will re-emerge in the second term sooner than you might think. Labour's spending plans are pretty robust until the end of the present spending review in 2004. The forecasts allow for a small economic downturn. But what happens then? Talk of a black hole in Labour's plans is an overstatement: there is little risk that public spending will have to be cut. But its rate of growth may have to be reduced. If the present real increases of 3.8 per cent a year were to continue after 2004, projections suggest that the government would face a revenue shortfall of £5bn a year.

If economic growth falters (and higher taxes are ruled out), spending growth could be forced down to a negligible figure: given that public sector inflation tends to outstrip the retail price index, growth of 1 to 1.5 per cent probably represents, in effect, stagnation. But even if economic growth is sustained, ministers will have to cope with a gap between expectations of improvements in public services and what will have been achieved by 2004. With ten-year plans for health, transport, schools and crime, Labour has already committed itself to substantial (if as yet largely uncosted) spending increases. During the campaign, Tony Blair repeated his "aspiration" to match the EU average for health spending by 2006. But that target won't be met unless the present rate of spending growth is at least maintained.

The obvious solution is to raise taxes in 2004-06. Labour has not ruled this out - only certain kinds of tax increases have been declared unconscionable. But the problem is that these are the fairest ones - only income tax and national insurance contributions are directly related to ability to pay. Other options, such as excise duties on tobacco, alcohol and fuel, are regressive - they hit the poor harder than the rich. Or they fall on business, a move Blair is unlikely to sanction. There are always surprise options - a windfall tax on oil company profits, say - but the opportunity for other significant "stealth" taxes has narrowed. The public may even dislike such taxation more than it does income tax.

If all this seems some distance away, it isn't. The present spending review ends in 2004, but the next one overlaps it, beginning in April 2003. So the spending plans will be announced in the summer of 2002 - which, in turn, means that preparation for them begins more or less immediately. The tax question, in other words, is on the agenda now.

Blair, it is said, will spend the next two years persuading us about the euro. But there's another European issue: at 37 per cent of GDP, the UK's tax share is 4 per cent lower (the equivalent of £20bn a year) than the EU average. The PM has a second big job of persuasion on his hands.

Michael Jacobs is general secretary of the Fabian Society. His book Paying for Progress: a new politics of tax for public spending is published by the society (£9.95 from bookshops)