Can and/or will the Government raise taxes again after last year’s Budget and if so how might they do it? Dr Dan Appleby, Chief Investment Officer at Blackfinch considers the possible options.
This is an extract from the full Blackfinch CIO Outlook report – see HERE.
Can the Government raise taxes again? It is certainly the expectation if we believe the many headlines. Let’s look at the four main revenue drivers, making up about two-thirds of tax receipts.
Income Tax
The largest revenue generator, but the Labour manifesto promised not to raise taxes on “working people,” so this would be politically damaging. Raising income tax would also reduce the potential for discretionary spending in the economy and would therefore reduce growth expectations.
Corporation Tax
Politically risky given the huge increase in employer National Insurance Contributions last year. It would also slow business investment further, and signs are that hiring is already slowing.
VAT
Another potential hit to discretionary spending if this tax is raised. It would also be inflationary and therefore risk the Bank of England holding off on further interest rate cuts.
Employees’ National Insurance Contributions
This would be another way to reduce the net amount received in payslips and in turn reduce demand. It would also be interpreted as a tax on working people.
Admittedly, the above is a broad-brush approach to tax policy, but it highlights the challenge of pulling the tax lever even further after last year’s hike. Other policies, such as wealth taxes, are also being proposed to solve the black hole. The problem with a wealth tax is that it almost never works because high-net-worth individuals are highly mobile; hence it results in capital flight and reduced investment. Switzerland is one example whereby a wealth tax has been a relative success, but this is largely due to other taxes, such as a capital gains tax, not being imposed. As such, the UK already has forms of a wealth tax by applying tax to capital gains.
It can be useful to apply the Laffer curve when discussing tax policy. It illustrates that tax revenue first rises but then falls as the average tax rate increases. Simplifying, if the overall tax rate is 0% then your government revenue will of course be zero. However, increasing this tax rate does not lead to a linearly increasing rate of tax revenue. For example, in the most extreme case where the tax rate is 100%, there would be zero incentive for people to work, or business to invest, and your economy shuts down.
There is an optimal point in between a tax rate of zero and 100% whereby tax revenue is maximised without stalling the economy. Judging by the past 12 months since the Budget, the UK is likely already past this optimal point. As it stands, the tax burden is set to be the highest since records began, stretching back to the end of World War II.
Consequently, increasing tax will be hard to do on the 26 November. Yet we are likely to see taxes rise as the chancellor has set two key fiscal rules:
- Day-to-day government spending must be met by tax revenues (no borrowing for regular operating costs).
- Public debt must be falling as a share of GDP by 2029-30.
We can interpret the first rule by saying the chancellor must raise taxes to pay for more spending. In turn, debt issuance will be reduced as more tax revenue flows into the Treasury, and this will achieve rule 2.
This ignores the Laffer curve by assuming raising taxes commensurately increases revenue without any impact on economic growth. But the bigger issue is one of spending, rather than revenue generation. Looking at this further, the chart below shows the breakdown of headline government spending as a percentage of GDP. The three biggest areas of increased spending across the dataset are: debt interest, health, and state pensions.
Rising debt interest costs is a symptom of a government increasingly spending more than it generates in tax revenue. Issuing more debt to cover the gap comes at a cost of higher interest costs, as we can see in the chart.
Health is a close second place for increased spending as a proportion of the economy. Health being the NHS. If we started with a blank piece of paper, it is highly doubtful that the NHS would be created in the form it is in today. We cannot, of course, start afresh with the NHS, but it is unlikely that increasing spending in the way that Figure 2 shows is the answer. Already the budget for 2025/26 is about £200 billion, up from £121 billion in 2019/20. As a policy, we need to improve productivity and value for money in the NHS. The process to do this is far trickier, but simply increasing spending as a proportion of the economy does not look sustainable.
The third biggest increase in spending as a percentage of GDP is the state pension. Current policy is for the ‘triple lock’ to increase state pensions by the greater of 2.5%, the previous September’s inflation rate, or the increase in average earnings. Given that private earnings growth rose 4.7% year-over-year to July, the state pension will now likely rise by this amount next April.
Questions have been raised on the sustainability of the triple lock policy. Even Sir Steve Webb, the minister who launched the system, has noted that it cannot continue in perpetuity. But further commentators have noted that the state pension may not be sustainable regardless of the triple lock, and that we must focus on private means of funding retirement in generations to come.
Means-testing the state pension has also been proposed, and the chart suggests that this might be necessary.
The political problem to the above is that these radical changes do not win votes. We saw that reforms to the welfare system failed in parliament only months ago, noting that adult social care and welfare benefits are not an insignificant amount of government spending and are expected to increase as a proportion of our economy.
Hence this coming Budget is largely expected to be a repeat of what happened last year. We will probably see tweaks to taxes, such as freezing income tax thresholds again and applying National Insurance on rental income, but it is speculation at this stage.
It is highly unlikely that we see the radical reforms that are required. Until we do, the UK will maintain its spending problem and simply hope that it can grow its way out of it.
