Speculation has reached fever pitch about the contents of the government’s forthcoming Autumn Budget. This follows the assessment of the highly respected NIESR (National Institute of Economic and Social Research, Britain’s oldest independent economic research institute) that the government is more than £40 billion adrift of the “fiscal rule” of achieving balance within five years. Allowing for a safety margin of £10 billion, that means a requirement for £51.1 billion, either in extra taxes or lower spending or both, annually by 2029-2030.
Slow growth, unexpectedly high inflation, disappointing tax revenues and overspending have caused the government’s finances to deteriorate rapidly. The promise of chancellor Rachel Reeves, that last year’s swingeing tax increases would be the last of this parliament looks set to be broken.
Most of the speculation has centred on tax increases on the well-off, whether on property, income or overall wealth. This is partly due to the Labour Party’s manifesto pledge not to increase the rates of income tax, national insurance or VAT; partly because there is little that excites the left more than the prospect of raising taxes on the better-off; and partly because the media loves scaring people about taxation.
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Labour's unintended consequences
However, there is abundant evidence that last year’s tax increases have been counterproductive, slowing economic growth, reducing compliance and encouraging taxpayers to change their behaviour, even their residency, to reduce tax. These appear to be factors that the government and its Treasury advisers grossly underestimated, if it considered them at all. Or maybe they just didn’t care. The taxes were motivated by revenge on the government’s enemies as much as on raising revenue.
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In theory, there are three ways Reeves could address the problem: cut spending, raise taxation or abandon the fiscal rules constraining the government’s room for manoeuvre. Given that even modest reductions in the growth of welfare spending have been defeated by backbench revolts and that increases in spending have been built into the government’s strategy, cutting spending is not an option.
Abolishing the fiscal target and allowing national debt to go on increasing may seem attractive but the cost of borrowing has continued to rise even as the Bank of England, more concerned to help the government than to exercise its theoretical independence, cuts interest rates. The cost of ten-year debt has risen to 4.7%, close to its January peak; that of 20-year debt to over 5.4%.
Some economists have been “crying wolf” about the risk of a spike in gilt yields, as supply continues to increase but demand drops away. So far, the trend has been slowly upwards, but that could change; the point about the parable of the boy who cried wolf is that nobody believes him when the wolf eventually arrives. Scaremongering has proved premature, but crises blow up very quickly. Anatole Kaletsky of Gavekal points out that rigid adherence to the fiscal rule leaves the chancellor unable to respond to an economic downturn. “Rather than benefiting from the Keynesian automatic stabilisers that have underpinned macroeconomic management since the late 1930s,” he writes, “the UK government has embraced a procyclical demand policy that might have been designed to amplify economic instability”. This is true but is the result of successive governments operating too close to the fiscal edge rather than leaving themselves room to respond to unexpected shocks.
Supply-side blunder
Kaletsky is on stronger ground criticising the government’s fiscal policy. “Starmer’s ban on any change to headline tax rates has compounded the demand-side error of pro-cyclical fiscal tightening with a supply-side blunder: imposing high marginal tax rates on a narrow base. This distorts the economy structurally, discourages investment, provokes political resistance, and encourages avoidance – guaranteeing disappointing revenue yields.”
He points out that “90% of British workers have qualified for big tax reductions since 1990” so that “fewer than 10% of taxpayers now bear the entire burden of financing the expansion of Britain’s welfare state, a shift to what may be the world’s most progressive income tax structure [that] occurred almost entirely during the 15 years of Conservative government from 2010 to 2024”.
He shows that “median British workers pay less tax than those in other rich economies”, leaving Britain’s finances dependent on “a very small minority of high earners who would probably prefer to abolish or bankrupt the welfare state rather than to pay ever higher taxes”. He goes on to argue that “the obvious – and, in my view, the only – solution that will ultimately convince the markets is for Britain to increase income tax and reverse the fiscal restructuring of the past 25 years”.
In other words, increase the basic rate of income tax to 22% and then to 25%. This, he argues, would restore bond investors’ faith in the sustainability of government finances, increase confidence and restart growth. More of government services would be funded with revenues contributed by the citizens who benefit from them. The NIESR also says that freezing tax thresholds and raising the standard and higher rates of income tax by 5% would close the fiscal gap, so Kaletsky is not alone.
The problem is that such a policy would drive a coach and horses through Labour’s manifesto commitment. For that reason, Kaletsky doesn’t expect this to be implemented in the Autumn Budget. Instead, “Reeves will likely propose intolerable tax increases that would extinguish any lingering hope of reviving growth – and prove politically unviable. The resulting backlash could spark a financial crisis and force a Black Wednesday-style U-turn in 2026.” Kaletsky believes that such a U-turn, which he thinks is inevitable, combined with a relaxation of the fiscal rule would, as in 1992, be “an economic liberation that could spark an unexpected national revival and growth boom”.
A fresh start?
There are, however, some problems with the 1992 analogy. Then, Britain was in recession with high interest rates and sterling tied to the over-valued deutschmark, providing no hope of escape. Breaking the link enabled interest rates to be cut and sterling to fall, though all the fall was recovered in the subsequent economic recovery. By 1997, the economy was growing strongly, the government’s finances were heading for surplus and taxes were being cut.
It’s very hard to see raising income tax as having the same effect, even if it would stabilise bond yields and interest rates. Moreover, despite the success of the 1992 U-turn, the Conservatives still lost the subsequent 1997 election decisively. Labour backbenchers will be well aware of this. Kaletsky is probably right – there is no alternative – but that does not mean that backbenchers or other members of the government will support it. It is more likely that the government will fall and be replaced either by a national government, as in 1931, or by an election.
That may sound like bad news but it will pave the way for a resolution. Several countries have faced a fiscal and economic crunch but have emerged revitalised. Not just the UK in 1992 (arguably a false dawn) but also Sweden, Greece, Italy and, most recently, Argentina. New governments implemented what was previously politically unthinkable, regained the confidence of the currency markets, deregulated, made government more efficient and revived growth. It just won’t happen under the current government.
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