Labour’s tax illusion

The world has changed, and policy must change with it.

Illustration by John Holcroft / Ikon Images

Rachel Reeves wanted last year’s Budget to be a one-off “corrective” event. The Chancellor raised taxes by £41.5bn – the largest increase as a share of GDP since 1993 – and confirmed the removal of winter fuel payments from most pensioners.

Rather than repeating such measures, Ms Reeves’ hope was that higher economic growth would liberate her. But it has not. After falling by 0.1 per cent in January, GDP has shrunk in four out of the seven months since Labour entered office. The “stability dividend” that ministers believed would accompany the end of Conservative rule proved illusory.

As a consequence, the “headroom” of £9.9bn that Ms Reeves maintained above her fiscal rules has been wiped out. A Chancellor who vowed there would be “no return to austerity” is now accused by Labour MPs of resurrecting it.

Welfare cuts of £5bn – the biggest since George Osborne occupied the Treasury in 2015 – were announced ahead of her Spring Statement. Unprotected departments, such as the Home Office, justice, transport and local government, have been asked to model real-terms cuts of between 6 and 11 per cent.

Talk of a return to austerity is exaggerated. Ms Reeves reasonably points out that she increased day-to-day public spending by £190bn and capital investment by £100bn in her Budget. But in areas burdened by rising demand, such as social care, prisons and children’s services, real-terms cuts will have consequences.

Faced with this, some inside government are appealing to the Chancellor to emulate Germany’s “war Keynesianism” and revise her fiscal rules. Yet doing so is far harder than often implied. While Germany’s national debt stands at just 62.9 per cent of GDP, the UK’s is 95.5 per cent (the highest level since the early 1960s). Berlin’s €1trn investment in defence and infrastructure also prompted the largest rise in borrowing costs since the Cold War.

Ms Reeves has already changed her fiscal rules once, adopting a broader definition of debt in order to create more room for investment. She is rightly wary of provoking a market revolt through further loosening. The Truss debacle in 2022 was not only a political gift to Labour – it was also a warning to all parties that there are hard limits on British fiscal policy.

A more plausible argument can be made for further tax rises. Though Ms Reeves’ Budget appeared dramatic, it was a response to an untenable fiscal position. Jeremy Hunt, her predecessor as chancellor, cut National Insurance on employees from 12p to 8p at a cost of £20bn. Only by pencilling in undeliverable spending cuts could Mr Hunt afford this largesse. Last year’s Budget averted these – and provided major increases in NHS spending and green investment – yet, alone, it cannot ensure a renewed public realm.

When Ms Reeves addressed the Confederation of Business Industry last November – amid business discontent – she vowed she was “not coming back with more borrowing or more taxes”, declaring that her Budget had “wiped the slate clean”. But the Chancellor has since used less emphatic language – and with good reason.

Even before the election of Donald Trump, Ms Reeves’ vow looked dubious. But the UK now faces the threat of weaker global growth and the cost of higher defence spending. In this new, darker world, the Chancellor may well have to deliver a Budget closer to her first.

To date, Ms Reeves has reaffirmed Labour’s election pledge not to raise income tax, VAT or National Insurance (on employees) – which together account for almost two thirds of tax revenue. Yet unless growth improves dramatically, she will soon have to revisit it – as she should.

Though the UK’s tax take has risen to a postwar high of 36.4 per cent of GDP, it remains comfortably below European counterparts such as France, Germany and Italy. Indeed, the average earner enjoys the lowest effective personal tax rate since 1975 (owing to Conservative reductions). If Britain is to maintain fiscal stability, bolster national security and improve public services, it must shed its illusions over tax. Middle earners – not just the wealthy – will need to contribute more.

The world, as Ms Reeves is fond of saying, has changed. She should use her next Budget to explain why tax policy must change with it.