Is Labour on the brink of a crisis?

“For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle,” said Winston Churchill. Governments worldwide have tried to prove him wrong, without success, affirming Einstein’s observation that “insanity is doing the same thing over and over and expecting different results”. Adam Smith wrote over 250 years ago that “little else is requisite to carry a state to the highest degree of opulence, but peace, easy taxes and a tolerable administration of justice”. Ronald Reagan quipped that “I never met a tax cut I didn’t like”, or, by implication a tax increase he did like. But in the view of the modern world, “history is bunk” (Henry Ford), and the wisdom of the past should be forgotten.

Hence, in response to Britain’s high national indebtedness (over 100% of GDP) and the dire outlook for its finances, left-leaning politicians, newspapers, think tanks and the Treasury have spent a great deal of time and effort in the game of Fantasy Tax Increase, drawing up lists of what taxes they would most like to increase. The causes of Britain’s fiscal crisis are simple. First, the government’s fiscal response to the Covid outbreak was grossly irresponsible (but hugely popular at the time). Second, the lowest interest rates in history facilitated extravagant public spending – witness HS2. Third, the slowdown in GDP growth since the 2008 financial crisis limited growth in tax revenue.

Higher growth would solve the problem, as it may be doing in the US, by generating higher tax revenue and reducing the need for welfare spending. But measures to encourage growth only bear fruit in the long term and may cost money in the short term. Governments tend to focus on the electoral cycle of the next five years, ensuring policy failure, rather than the next 25 years. In the shorter term, the government believes it has to either raise taxes or cut spending. The problem with the latter is that no government in the UK has ever done more than slow down the rate of increase, and even that leads to howling about “austerity”, which increases pressure for a catch-up increase when the crisis passes.

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Labour's tax rises

That leaves tax rises, which the taxpaying voters hate but the growing number of non-payers don’t, especially in a country more motivated by levelling-down than by encouraging aspiration. Hence Rachel Reeves’s Budget focused on upping taxes few people pay, such as capital gains tax and inheritance tax, and the removal of their tax breaks. But “those with the broadest shoulders” are also the most mobile and canny, with the best accountants and lawyers. The likely result is far less, if any, additional revenue than hoped for – as the Treasury has pointed out to Reeves.

Increases in income tax, expenditure taxes or National Insurance would be harder to avoid but politically suicidal, and might not work. In recent months the monthly fiscal deficit numbers have consistently proved worse than expected, probably thanks to the failure of the tax increases imposed by the last government to raise revenues. There is a political consensus that the solution is higher GDP, growth but that would require reforms with which Labour will struggle. It says it is committed to reforming the NHS, whose declining productivity has been a drag on the whole economy. Labour has also promised planning reform to accelerate the construction and reduce the cost of new infrastructure and housing. But the proposals focus on the application of the sticks of compulsory purchase of land, the confiscation of planning gain and diktats to local authorities – without the carrots of incentives. It promises a bonanza for lawyers.

The pandemic energised the private sector but had the opposite effect on the public one. As Janan Ganesh of the Financial Times says, “Labour is the political arm of the public sector middle class”, making deregulation and increased efficiency not only unlikely but almost inconceivable. With the coal mines all closed and North Sea hydrocarbon production in decline, energy has become a serious drag on the economy. Increasing national energy self-sufficiency and reducing its cost to firms and consumers would be good for growth but the government is determined to go in the opposite direction. It plans to shut down hydrocarbon production, while its target of net zero by 2030 involves a massive cost to consumers.

Finally, the number of people of working age living on benefits is now 4.2 million, a rise of one million since 2019, and is expected to rise by 30% by 2030. This both reduces tax receipts and increases spending. Benefit reform is urgently needed but highly unlikely. The implementation of these reforms would buy the government time but without them, tax revenues will continue to undershoot and expenditures to overshoot. Next year, Reeves is likely to impose more general tax increases, probably breaking Labour’s pledge not to “raise taxes on working people”, in a desperate attempt to appease the bond market, on which the government relies to finance its deficit.

This is already a problem. The yield on 10-year gilts has fallen from 4.6% a year ago to 4.2%, having been 3.75% a few weeks ago, but the US 10 Year Treasury yield has fallen more, from 5% to 4%, despite higher growth. If, as is likely, UK gilts continue to underperform, yields could reach 6% next year. This will significantly worsen the public finances. If the outlook for the economy, the budget deficit, national indebtedness and the government’s popularity look bad now, they will look a lot worse in a year’s time. A storm on the scale of the 1976 crisis is likely. The question then will be whether that will lead to the humiliation of a dramatic policy U-turn on spending and taxes, as it did 50 years ago, or whether the government will go for the full kamikaze.

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