It's hardly a secret that Reeves has inherited a difficult fiscal situation. The country is paying – and borrowing – more for services which, on many measures, are deteriorating.
Rachel Reeves will deliver the budget on 30 October, the first by a female chancellor of the exchequer. After 14 years in opposition, the Labour party has to turn rhetoric and plans into an economic strategy. Next week’s budget is likely to be one of the more consequential in recent years, setting a framework for taxation, spending and public borrowing for the rest of this parliament.
It's hardly a secret that Reeves has inherited a difficult fiscal situation. Taxes are on course to reach their highest level since 1948 and government debt has exceeded 100% of GDP, its highest level since the 1960s. Public expenditure as a share of GDP has only been higher in recessions, yet satisfaction with public services is at record lows. The country is paying – and borrowing – more for services which, on many measures, are deteriorating.
Reeves has also inherited plans from the previous government that would mean swingeing real-term cuts to many departments, reductions in public investment as a share of GDP, further tax rises and significant public borrowing.
The UK’s fiscal situation is difficult, but not unique. The US, Japan, France and Italy also borrowed on a vast scale to counter the impact of the financial crisis and the pandemic. Most have suffered the same combination of slowing growth trend and rising welfare and health costs as the UK. All have seen sharp increases in levels of public indebtedness.
The UK budget will outline departmental spending plans for the next fiscal year (2025–26) and the overall funding for subsequent years. In the spring, the government will conduct a spending review that will set out detailed departmental spending plans beyond 2025–26.
The choices and trade-offs that Reeves announces next week will set a course for Labour’s economic policy for the rest of this parliament. Three issues will define this budget.
The first relates to public services. Rachel Reeves has pledged no return to austerity although, perhaps helpfully, there is no agreed definition of austerity. Reeves has inherited plans, laid out by her predecessor, in the March budget, for significant real-term cuts to expenditure in departments, including justice, transport, local government and the Home Office, accounting for about one-third of all public spending.
Just to maintain real-term funding for these so-called unprotected departments – something the chancellor seems likely to want to do – would cost £23bn by 2029–30, according to the Resolution Foundation. Together with the cost of higher public sector pay, increased health and infrastructure spending and selective rises for other priorities, it seems quite plausible that Reeves will announce increases in public expenditure of as much as £40bn in the budget.
This is a significant sum and would be a marked change in the trajectory of public expenditure compared to the March budget. However, given low levels of satisfaction with public services and the scale of the squeeze on many departments (local government spending, for instance, is down by 23% per capita) even £40bn extra public spending would not transform public services. In time, the effects of public service reforms, increased investment and sustained growth should help. But peoples’ day to day experience of public services won’t change overnight. On that measure at least, austerity will not be banished.
The second issue for the chancellor is whether to change the rules that govern public borrowing to allow for increased spending. I think this is quite likely, with the chancellor switching to a definition of debt that would create more headroom for capital investment.
Reeves will be acutely aware – especially in the light of the ill-fated Liz Truss budget of 2022 – that whatever changes are made need to command the confidence of bond investors. There is a good economic case for borrowing in order to invest, but this is still additional public borrowing. Britain has a 25-year record of frequent changes to its fiscal rules, almost always in favour of more borrowing. Resetting the fiscal rules today, in a world of high interest rates and government debt, is no free lunch. A credible focus on ensuring public investment is deployed wisely to boost growth would go some way to reassuring investors. But my guess is that any changes that allow for increased capital spending will also imply hard limits for current public spending. That would be at least as much a signal for Reeves’s cabinet colleagues as for the bond market.
The third question relates to taxes. It’s not a question of whether taxes will rise, but by how much. As a result of decisions by the previous government, the tax burden is set to rise by about £24bn by 2027, mainly due to the freezing of personal tax and national insurance allowances and increases in stamp duty and fuel duty. In addition, Labour’s manifesto outlined plans to raise a further £9bn from the imposition of VAT on independent school fees, a windfall tax on oil and gas companies and higher taxes on UK non-domiciled residents and private equity carried interest. (Press reports suggest that some planned measures may be diluted on concerns about adverse behavioural effects and/or lower-than-anticipated yields.)
Where else could the chancellor raise taxes? Labour has ruled out rises in income tax, national insurance, VAT or corporation tax. Recent press speculation has focussed on the possibility of increases in employers’ national insurance contributions. Estimates from HMRC suggest that raising the employer’s NI contribution by two percentage points would raise around £17bn in 2025–26. Though a charge on the employer, over time it seems likely that employees would pay in the form of lower real wages. (It is partly for this reason that the OECD scores an increase in employers’ payroll taxes, such as national insurance, as a tax on employees.) Capital gains tax, inheritance tax and pension tax reliefs also feature prominently in recent press speculation about potential tax rises.
Tax increases – be they inherited from the Conservatives, promised in Labour’s manifesto or likely given the scale of the pressures on public services – could add up to the £40bn level. The tax burden has risen sharply in the last 15 years, but it has further to go.
Who is paying these taxes? Certainly, higher earners. As Paul Johnson of the Institute for Fiscal Studies noted earlier this year: “[the] top 1 per cent pay 29 per cent of all income tax now, up from 25 per cent in 2010 and 21 per cent at the turn of the century”. By contrast, taxes on average incomes in the UK are relatively low compared to other countries. OECD data shows that there is no country with higher public spending than the UK that has lower taxes on the average worker.
Reeves aims to improve public services without increasing taxes on such workers (or what Labour, more vaguely, calls “working people”). She also wants to increase public investment and raise Britain’s growth rate – all the while keeping debt under control and bond investors onside. To say this is a difficult balance to strike is an understatement. How she does it will help define this government.
