'Rachel Reeves’s tax rise will crash the economy'

The M&S boss, Stuart Machin, has already called it. Presenting his company’s results last week, he warned that his affluent, but hardly mega-rich, customers were already worrying about the tax rises chancellor Rachel Reeves has made clear will have to be imposed in the Budget later this month and are already cutting back on spending.

We don’t know how much the rise will be yet. But it seems clear that Reeves is going to break her manifesto pledge and raise income tax in the Budget late this month. In a very odd address from Downing Street last week, she prepared the ground for that by blaming the mess she inherited for the deteriorating state of the public finances. Leaks from the Treasury suggest the decision has already been made. Reeves will be the first chancellor since Denis Healey in the 1970s to put up the basic rate, and that will hit all the UK’s 34 million employees.

We can all debate whether that is politically viable, or whether the choice to raise income tax is better than the alternatives (my view is that, while it would be preferable to control spending, if the government can’t do that, then raising income tax will do less damage to the economy than lots more levies on business and “the rich”). But there is a far more significant question. What impact will a rise of, say, 2% in the basic rate of income tax have on the wider economy?

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Unfortunately, it is not going to be good. First, and most obviously, it will hit demand. People will have less take-home pay every month, and that will inevitably mean they will have to cut back on their spending. Demand is already very weak, and while retail sales managed a 0.5% rise this month, footfall on the high street has been falling for six months. After a tax rise, it will fall even further. Even worse, everyone will expect taxes to rise in the next Budget as well, and the one after that. Consumers will have to save more and spend less to protect themselves from rising taxes, and that means that demand will keep on falling and the economy will start to shrink.

Income tax is a tax on working

Next, it will damage incentives to work. Britain already has a huge problem with the number of people who have simply given up on work. There are currently more than nine million people of working age who don’t have any form of employment. Of those, a few are students, and some have taken early retirement, but 7.4 million are on disability benefits. There are another 1.7 million people who are unemployed, taking the total close to 11 million. The welfare bill is already more than $300 billion a year, putting a huge strain on the public finances. One of the government’s major challenges will be getting many of those people back to work.

And yet, if people face higher marginal rates of tax as soon as they take a job, that will inevitably be more difficult. Indeed, plenty more people might decide sickness benefits are a better option. Higher up the income scale, if the top rates rise to 42% and 47%, as they almost certainly will, we should expect more people to opt for early retirement, or to scale back on their hours if they are self-employed. After all, income tax is a tax on working, and the more we tax it, the less we can expect.

Finally, it will damage investment as companies anticipate weaker sales. If overall demand is falling, and looks like it will remain subdued as taxes carry on rising, and if labour is scarce as more and more people decide to leave the labour market, then there is very little incentive to open up new shops, cafes, warehouses or factories. It does not hit business as directly as a rise in corporation tax, or as last year’s increase in the rate of national insurance that businesses are charged on everyone they employ. But that does not mean there is no impact. It makes the UK an even less attractive place to invest than it already is.

The only real fix for the UK’s economic stagnation is to reduce the size of the state and make what remains more efficient. Raising income tax might keep the bond markets happy. But it won’t do anything for longer-term stability, nor will it restore confidence. The economy is already flat – a tax rise will push it into recession.

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