Why raising taxes substantially is critical for the next Labour government to be sure of achieving its missions

 

My series of posts on detoxifying government debt was all about why Labour should not be afraid to increase public investment substantially. Public investment should be matched by borrowing because future generations benefit from individual investment projects. The same is not the case for most day to day (current) public spending. If the economy is not suffering from deficient aggregate demand, it makes sense to match increases in day to day spending with higher taxes. A fiscal rule that does this (often called the ‘golden rule’) makes sense.

That day to day public spending needs to increase substantially should not be in dispute. It is hard to think of any area of public spending that is not suffering badly after years of cuts, without any significant cut in what that spending is designed to achieve. The Institute for Government and CIPFA’s Performance Tracker shows that performance in most services is worse than before the pandemic, and much worse than it was in 2010. Our prisons are full, more people of working age are too ill to work, councils are going bankrupt, and poverty is increasing rapidly because benefits are too low or needlessly restricted. In addition many public sector workers have seen their relative pay squeezed over many years leading to either severe shortages or reliance on workers from overseas.

Additional public investment, together with some reforms, may ease these pressures a little, but they take time and will not be enough on their own to make a noticeable difference to public service provision over a five year period. It is also clear that the majority of voters want to see the next government achieve more in terms of improving public services than marginal increases in efficiency. Over the last six months the Conservative government has put cutting taxes at the centre of its economic offering to the public and their poll ratings continue to fall.

The idea that enough of the electorate will vote against any party proposing tax increases is a political myth, encouraged of course by a media dominated by a right wing press. As this paper by Rosa Hodgkin shows, historical evidence suggests that popular attitudes to personal taxes have not changed much since the late 1940s, and there is no new popular resistance to raising taxes regardless of circumstances. Gordon Brown was incredibly nervous about raising NIC to get more money into the NHS, but it turned out to be very popular. Most voters currently recognise the dire state of public services, and have grown tired of politicians that pretend this can all be fixed without spending additional money.

Yet the next election will be framed by the current government in a magical world where taxes can be continually cut and public services will do better with even less money than they currently receive. The government can pretend this because it knows it is very likely to lose, but thinks tax cuts shore up its core vote (and keeps its own party together) and creates problems for Labour. Labour’s response is to avoid those problems in opposition by accepting these tax cuts, but if they win that makes their problems in government that much harder.

All this means that in the real world the next government will have to raise taxes. The tax cuts announced so far, together with anything more to come before the next election, just satisfy the falling debt to GDP rule adopted by both main parties because projections are based on politically impossible assumptions about public spending. They imply cuts to prison spending when prisons are full so prisoners are having to be released early, and cuts to local authority spending when many councils are on the verge of bankruptcy.

Of course the next government could be lucky, either because growth exceeds the OBR’s projections or taxes are unexpectedly high compared to GDP [1], but they would have to be very lucky to avoid tax increases just to stop the currently terrible level of public service provision getting worse. However, no government should plan on the basis of being lucky. Indeed good governments should have plans that are robust to being unlucky in terms of how the economy progresses.

So if Labour wins the next election they will almost certainly have to raise taxes anyway, just to stand still in terms of public services. This is something Rachel Reeves must know. Any Chancellor who hopes something will turn up is destined to fail badly. There are two paths that Reeves could follow. The first is to hope she can find enough taxes to increase that she hasn’t already pledged not to raise, so she can say that she is not breaking any commitments made before the election. The second path is to break those commitments.

How feasible the first path is will depend on how much further Reeves is forced to go before the election. She has already ruled out raising income tax or personal NIC payments, as well as corporation tax. She has said she has no plans to raise taxes on capital gains, although ‘lack of plans’ is not quite the same as a commitment. We can expect the Conservatives to try very hard to extend the range of taxes which Labour commit to not raising during the election campaign, and may even try to steal more of the small number of small tax increases Labour are committed to, as they did in the last Budget.

The big danger of the first path is that it leaves too little room for Labour to make real progress on its five missions over a five year period, and in particular its mission to get the NHS back on its feet. If the OBR projections for the economy or government finances turn out to be too optimistic, there is a real danger that each Budget Reeves gives will be a scramble to find more tax increases just to stand still. It will seem to voters that taxes are going up, yet there is little to show for it. [2] As a result the first path is very risky in political terms.

In particular, the first path is not robust to uncertainty about growth in the economy. Despite all the detailed ideas and analysis in her recent Mais lecture, Reeves knows that while governments can positively influence economic growth it cannot control it [3]. Year to year growth is influenced by countless factors outside the government’s control. In addition projections of tax receipts for any given level of growth can easily be wrong, as Gordon Brown found out as Chancellor (see footnote [1]).

The second path has the immediate cost of breaking a pre-election commitment, as well as any unpopularity that comes from raising a tax paid by most people. However I expect both are already ‘priced in’ by voters to a considerable extent. However it is a more robust path than the first. It raises more tax, so is robust to a modest deterioration in the economy or public finances. The government still has a chance to achieve its missions and better public services even if growth in the short term is weak.

If economic growth is stronger than expected, as I noted in my last post, additional public investment is in danger of hitting resource constraints, and in particular a shortage of labour. To increase both current public spending (e.g. training more nurses, doctors and teachers) and public investment without hitting these resource constraints requires more modest growth in private consumption, which higher taxes will achieve.

This concern about overheating the economy is also the focus of a recent post by Chris Dillow. He argues that if the economy remains strong this is not the time to be running large fiscal deficits on day to day spending, and I agree. I also agree that in this situation raising taxes only on the rich [4], however desirable that may be on equity grounds, does not solve the macroeconomic problem because most of this money would come out of savings rather than consumption. This is why, if the economy remains strong, what I call the second path Reeves could follow needs to involve taxes on most people. However Chris also argues against the kind of simultaneous increase in spending and taxes that this second path involves.

He has two main objections. The first is that tax rises will go against what Labour have said before the election. But as I have already argued, some tax rises are inevitable after the election under any government, because the public spending assumptions behind recent tax cuts cannot be delivered. If Reeves is unlucky with the public finances in the first few years, she may have to break these commitments anyway. The second objection is that it takes time to shift resources between sectors. However what I call the second path need not involve radical dislocation. What it needs to do is set out a plan for a steady improvement in resources going into the public sector, but also paying public sector workers better, which involves no resource relocation. Labour under Blair/Brown did this for the NHS in the early 2000s when the economy was healthy, and Labour can do it again.

There are three major advantages in Labour choosing the second path, which involves increases in taxes on most voters. First, it is a robust policy, allowing key Labour missions to be completed whatever the state of the economy. Second, most voters will be expecting public service provision to noticeably improve under a new government. Third, better public services are not just desperately needed in their own right, but in the case of the NHS at least would have knock-on benefits for the economy as a whole.

Against these advantages, the cost of going back on commitments made in an election based on your opponent’s fantasy numbers seems small. In political terms, there is no reason why a failed and very unpopular outgoing Conservative administration should be able to saddle a Labour government with underfunded public services for five years. For the electorate at the election after next, few will remember a tax commitment broken five years earlier, but a failure to achieve its missions of restoring the NHS and reducing the child poverty that stifles opportunity will not be forgiven.

[1] The history of the first ten years of the last Labour government is a good example of the latter. During his first set of Budgets Gordon Brown found that tax receipts kept coming in higher than Treasury forecasts. In the remainder of his budgets the opposite was true.

[2] I have in mind here slow growth or low tax receipts given projected growth. In a recession an expansionary fiscal policy is required to support the economy.

[3] A government’s ability to negatively influence growth is much greater, unfortunately, as the UK experience over the last decade and a half shows.

[4] The same is true for ‘windfall taxes’ on specific companies. I have argued that when interest rates are high there is a very strong case  for a windfall tax on banks, but it will not have much impact on aggregate demand.