Most people reading this will know that one of the Chancellor’s big problems that she will have to tackle in the November Budget is a downgrade to expected productivity growth. You might have read that lower productivity growth implies lower overall growth, which means less growth in incomes and spending and therefore less growth in taxes. Because the Chancellor’s key fiscal rule states that expected future taxes have to match expected future current spending, that means taxes will have to be increased in the budget. [1]
So how might the Chancellor increase taxes? Before the previous budget I looked at various options to tax the more wealthy while sticking to the pledge not to raise the big three: income tax, employee NICs and VAT. In the last few weeks the Prime Minister has failed to insist that this pledge still stands, and this has led to a lot of speculation that the Chancellor may be forced to raise tax rates for at least one of these big three. Faced with not just a productivity downgrade, but the need for more headroom and ending the two-child limit, the Chancellor needs to find a lot of money.
There are some obvious things to say about this. First, it would have been better to do this earlier. I’m not going to resist the opportunity to say this isn’t just hindsight on my part. When, shortly after gaining power, the Chancellor discovered the state of public finances was even worse than she expected and ended (temporarily it turned out) the winter fuel allowance, I wrote
“I still fear that Labour are underestimating the extent of money they are going to need to spend to restore public services. Promises they made during the election also limit the amount of taxes they can raise. Yesterday was the ideal opportunity to say that those promises had been made on the basis of false information. It was now clear that cuts to national insurance contributions over the last year were unaffordable, and that they would be reversed by Labour. That opportunity has been missed.”
Further political opportunities arose after the election of Donald Trump and his subsequent obsession with tariffs. Before the previous budget I wrote
“The problem the Chancellor has is that an increase in taxes of the order of magnitude required to end austerity is very hard to achieve while keeping her commitment not to raise income taxes, employees NIC or VAT.”
After the last budget I wrote
“However, the political danger of moving gradually, in part because one hand is tied behind your back (no tax rises on working people), is that you disappoint those who are naturally impatient to see improvements in public services across the board. A political environment where voters know taxes are rising but where problems in public service provision (including child poverty) continue to fill the headlines is not a comfortable one for any government, because it raises issues of competence in voters’ minds (where is the money going?). Equally risky is continuing to try and flatter the marginal voter (or petrol user!) when you are in danger of losing your political base. I suspect, once the immediate and rather predictable political controversy is over, this budget will be seen as the minimum that could have been done, and that something bolder might have been less risky in the longer term.”
I hope these quotes make clear that, when it comes to breaking their tax pledge, the phrase ‘better late than never’ applies. It is far better to break the tax pledge now than in a budget nearer the election, both from a political and economic point of view. The politics are obvious, but the longer the Chancellor appears wedded to this tax pledge, the more it will be asked whether this overrides her commitment to meet the fiscal rule involving the current deficit.
Furthermore, a downgrading of UK productivity growth reflecting recent poor performance can reasonably be blamed on Labour’s inheritance. Some will argue that the OBR’s reassessment is long overdue, and if it had occurred under the previous government then its cuts to employee NICs may well have been untenable. While it is impossible to know exactly why recent UK productivity growth has been so bad, one plausible cause is Brexit, and it may well be that the OBR’s previous assumption of an eventual 4% hit to the level of productivity from Brexit may be too low.
If the Chancellor does break the tax pledge, then I hope it will involve a rise in income taxes rather than a rise in VAT or personal NICs. A rise in VAT seems unlikely, given a recent statement from the Chancellor about wanting to reduce cost of living pressures and allowing interest rates to fall further. As the Resolution Foundation notes, internationally the UK stands out for its low personal income taxes. Higher income taxes are preferable to higher employee NICs because they hit all incomes, not just earnings.
From a political point of view, one way to soften the damage caused by breaking their tax pledge is for the government to both increase and reduce some of the big three taxes. The government is considering exempting electricity bills from VAT altogether (currently taxed at 5%), and this could be combined with higher income taxes. [2] Of course the net effect would have to be to raise revenue, but nevertheless the Chancellor could argue that she wanted to cut energy bills, and the only way she could do that in the current situation was to break her previous pledge.
Another possibility, suggested by the Resolution Foundation, is to cut personal NICs and raise income tax. This could be done in a way to leave most workers no worse off, but it would raise revenue because income tax applies to all income (including pensions) while NICs only applies to earned income. It’s an option that is attractive to many economists, because having two different taxes on earned income with different allowances and exemptions is messy and therefore inefficient.
What also seems clear from a political point of view is that if the Chancellor is going to break her tax pledge, she should do so in a big rather than small way. Labour will be attacked for breaking its pledge whether it does so in a big or small way, or to use economic jargon, there is a large fixed cost element in breaking the pledge. What she wants to avoid at all costs is finding herself in the same situation in a year or two years time.
Of course it is possible that all the talk of breaking the tax pledge is just the government managing expectations, and that when the Budget is announced Reeves will tell us that she has managed to raise enough taxes without breaking Labour’s commitment on the big three. This might avoid some short term political costs, but at the significant risk of much higher costs later on. As the quotes above make clear, it would be repeating the mistake the Chancellor made last year.
[1] If the Chancellor focuses on tax increases rather than spending cuts, this will mean that the expected share of public spending in GDP will rise a little. As regular readers will know, I think that if we are to get back to levels of public sector provision that we saw under the last Labour government, then the share of spending in GDP needs to rise substantially. This gets us a little way towards that. If you like using the austerity word, it means a bit less austerity.
Now lower GDP but unchanged public spending need not make us better off. Crucial here is what happens to public sector productivity. Lower private sector productivity will mean, other things being equal, lower private sector real wage growth. If the downgrade to total productivity is confined to the private sector, and if public sector real wages follow private sector real wages, then existing public spending plans will have room to employ more public sector workers and therefore raise levels of public sector provision.
[2] A zero VAT rate for electricity bills is a classic example of a measure which is easy to understand (and therefore politically attractive) but is also problematic in economic terms. It obviously discourages fuel economy. It gives most help those with high electricity bills, and therefore fails to concentrate help on those that need it most.
