In the second of a two-part series on the forthcoming Budget, Colm Murphy and Patrick Diamond make the case for revising the fiscal rules and raising direct taxation.
We have made the case that the Labour Government should expand the taxation of wealth, property, and capital. Yet it is clear that wealth taxes alone are no panacea. There is uncertainty about how much revenue levies such as capital gains tax will actually raise. CGT currently accounts for only 1.3% of UK tax revenues. Increasing the CGT rate will help, but it is not a magic wand.
Even if the Chancellor does extend the taxation of wealth, the medium-term credibility of the Government’s economic strategy rests on fixing the policy fundamentals. Two priorities to address are the government’s fiscal rules and taxes on income.
First, fiscal rules. The use of such rules is heavily criticised, but maintaining well judged fiscal rules still makes sense. The debacle of the 2022 ‘mini-budget’ exposed the risks of wilfully ignoring market sentiment in an open, heavily financialised economy. There is a relatively large volume of public debt in the UK and, as the National Institute for Economic and Social Research (NIESR) recently demonstrated, private investors must absorb an increasing share of debt issuance given the winding back of the Bank of England’s QE programme. No government can take fiscal policy decisions in denial of the importance of retaining positive market sentiment.
However, the undoubted need for self-imposed ‘fiscal rules’ does not compel us to stick to the current iteration inherited from the Chancellor’s Conservative predecessor. That’s important because the second rule – that the debt burden must be falling at the end of the 5-year cycle – looks unviable in the medium term as well as being an arbitrary goal. If faster economic growth does not materialise, the rule will be even more untenable.
If she follows the plans she inherited, Reeves would likely be forced to cut capital investment over the next three years. Yet such a move would torpedo the delivery of the government’s ‘missions’. In particular, it would undermine the government's growth strategy, as investment in growth-enabling sectors such as transport, housing, education, and health would remain anaemic. It would make it far harder for the new Government to achieve it aim of securing significant improvements in the NHS, a prerequisite to Labour’s re-election.
Consequently, as the OECD recently warned, the second fiscal rule risks condemning the UK to a permanent cycle of low growth, low investment and lower living standards. Strategic increases in borrowing to invest are therefore the most prudent approach, as long as the government invests in building public net worth, improving economic growth, increasing the preventative capacity of public services, and accelerating the green transition. The OBR recently estimated that an increase in public investment equivalent to 1% of GDP could generate a 2.5% increase in potential output over the long run. The investment really would pay for itself, as would measures that reduce economic inactivity such as additional spending on skills and support to help those with long-term conditions back in to work.
The fiscal regime that the Chancellor should follow must focus on actual constraints (given the reality of open capital markets and floating currencies): what key financial market actors are willing to tolerate under what conditions, and which indicators they use to decide. As the historian Jim Tomlinson might say, what narratives are gilt traders telling themselves? A falling debt-to-GDP ratio over a 4/5-year political cycle is a purely arbitrary choice by the government. Even the inevitable warnings about borrowing from gilt traders concede that the Chancellor could perhaps borrow an extra £20bn a year.
As long briefed to the press and recently confirmed by Reeves, the Treasury grasp this themselves. They are exploring various definitional tweaks to boost investment, including choosing a more accurate (and less restrictive) definition of assets. These will help with the forthcoming budget.
But we should not stop there. In the medium term, the Chancellor should ask the OBR to undertake a review of the fiscal rules to examine how they can be made compatible with the ‘mission’ of higher growth. That review could tackle more challenging but potentially more rewarding reforms, like the IMF’s suggestion of a ‘public sector net worth’ balance sheet that includes schools and hospitals as assets.
The second fiscal policy lever is direct taxation. To ensure the adequate long-term funding of public services, imaginative thinking is needed, including consideration of proposals such as the economist Dani Rodrik’s national sovereign wealth fund that invests strategically to generate future revenues for public services.
Ultimately, the Labour Government will have to re-visit the decision not to reverse the previous government’s cuts in employee National Insurance (NI) at some point over the next Parliament. That decision has blown a ‘hole’ in the public finances which makes it increasingly difficult to sustainably finance health and social care over the long-term given the costs of new medical technologies and treatments, alongside the structural pressures of an ageing society and rising expectations. The King’s Fund estimates spending will need to rise by 4 per cent a year in real terms over the next decade – way beyond what the government have so far promised.
The politics here are fraught because Labour made an explicit manifesto commitment on tax and NI. Nevertheless, they have little choice but to initiate a debate with the electorate about the taxes they are willing to pay in the future. Deciding instead to increase employer NI contributions, as the Treasury are apparently contemplating this time, will not solve the problem, not least because it can be (and will be) represented as a tax on employment. As underfunding the NHS results in spiralling waiting times and cancelled operations, the reluctance of politicians to properly face up to Britain’s taxing and spending dilemma has been debilitating. British politics is still crippled by the illusion that voters can enjoy Scandinavian-quality public services with American levels of taxation.
The experience of recent decades indicates that securing political consent for increased taxes requires greater transparency from governments. Although it will annoy experts and the Treasury, a viable political solution is to strengthen the connection between citizens and the taxes they pay through ‘hypothecation’: tying specific tax rises to extra funding.
The inescapable truth is that if Labour wishes to maintain high quality public services and address chronic underinvestment in the public realm, voters across the income distribution will need to pay more tax. Ministers must be willing to make the argument that tax is the down payment we all pay for living in a decent and fair society. They should be willing to initiate a vigorous dialogue with voters about future fiscal choices.
Dr Colm Murphy is Lecturer in British Politics at Queen Mary and the Deputy Director of the Mile End Institute. Patrick Diamond is Professor in Public Policy at Queen Mary and a former Head of the Number 10 Policy Unit.