The 3Rs: Reeves, Revenues and Resentment

I have said it many times before, but it is worth repeating that the on-the-day take of the UK Budget often misses much of the nuance. This is hardly surprising: we are bombarded with a huge amount of material which takes time to digest, and only once the dust has settled can we give a sober assessment, free from the imperative to say something quickly. But perhaps the most important takeaway is that we – and by we, I mean the electorate as a whole, but particularly politicians and the media – should stop treating a serious area of economic policy as if it were a piece of theatre. Fiscal policy has important implications, both at a microeconomic and macroeconomic level: The decisions taken on Budget day impact on household finances but also affect the nation’s creditworthiness. One might be forgiven for forgetting some of these bigger issues given the faux outrage generated by political opponents and the reaction in parts of the media (this is not a party political point: it is true irrespective of the party in office).

Communication breakdown

As for the framing of the Budget, shambles would be a polite description. Communication ahead of the Budget was characterised by the flotation of various fiscal ideas, as the government released a number of trial balloons, with the Chancellor Rachel Reeves hinting on 4 November that a manifesto-busting hike in income tax rates was on the cards. Just days later, however, the government rolled back on this policy. As the spin doctors got to work to explain the apparent U-turn, we were told that the official forecasts were likely to show a smaller black hole in the fiscal accounts than previously thought and that a rise in income tax rates was unnecessary. Instead a “smorgasbord” of smaller tax increases would be sufficient to ensure that the government could meet its fiscal rules. 

But on 28 November,  two days after the Budget, the narrative changed to suggest that in fact the OBR had informed the Chancellor as early as 31 October that she could still balance the current budget on a five year horizon, even without major tax hikes. Admittedly the margin was too small for comfort and some fiscal adjustment was still necessary, but it appeared to be a far less dramatic problem than we were led to believe.

Not too long ago, the pre-Budget period was characterised by ‘purdah’, with public officials prevented from making any comment on its content on pain of sanction. Once upon a time, monetary policy also used to be conducted in secret in the belief that surprising the market was the most effective means of policy control. The economic literature has since come to the conclusion that clarity and predictability are the corner stones of sound monetary policy. But this is not what we got in the four weeks prior to the Budget, which was characterised by mixed messaging and confusion, none of which helped to shore up fiscal credibility and served only to heighten market volatility. Silence can indeed be golden.

The shambolic communication extended to Budget day itself when the OBR’s main publication was released tothe public before the Chancellor had a chance to inform parliament of her fiscal plans. It is not for me to say whether that was a breach of the law but it was certainly a breach of protocol. Nor do I have any strong views as to what, if any, sanctions should be imposed. But Chris Giles, writing in the FT, noted that: “The OBR’s error is worse than other Budget leaks because the fiscal watchdog exists solely to improve the process and has failed in its main job. The disaster exposes the OBR to future political questions and undermines the case for independent economic institutions … If the OBR cannot organise its document handling, how can we trust it to get the judgment on productivity or the tax richness of GDP forecasts right?” 

Giles did not explicitly call for the OBR’s Chair, Richard Hughes, to be sacked but he certainly hinted that he should be left alone in the study with a pearl-handled revolver. This seems a little harsh given all the anonymous leaks to which we have been subject over the last month.

Was the economics any better?

The answer to that question depends on what we think is the primary objective of the Budget. In my view, those who believe the Chancellor did not do enough to boost growth are missing the point. In the words of the Parliament website, the Budget “is a statement … on the nation’s finances and the Government’s proposals for changes to taxation.” Essentially, the Chancellor has two instruments at her disposal – taxation and spending – to control two quantities (revenues and outlays). Using the tax instrument to target both revenues and growth is asking for trouble. Indeed, the Tinbergen rule states that there must be at least as many independent policy instruments as there are independent policy objectives to achieve them efficiently.

Focusing on the more narrow fiscal questions, however, a lot of awkward questions remain to be answered. Starting with the fiscal rules, the good news is that the OBR’s forecasts suggest they will be met. The Chancellor has a bigger buffer (£22bn) to accommodate any narrowing of the current surplus by 2029-30 (this was a mere £9.9bn in March). However, the OBR only assigns a 59% probability to the chance this will be achieved: While this is the highest in the post-Covid era, it is far from a ringing endorsement (chart above). 

The supplementary target for public sector net financial liabilities (PSNFL) to be falling in 2029-30 is also met in the central forecast, but the probability assigned to this target is just 52%. Indeed, a debt-to-GDP ratio currently close to 90% and set to go higher means that debt servicing costs are highly vulnerable to swings in bond yields. Around 9% of revenues are currently used merely to pay debt interest: At a time when there are so many other competing demands on public finances, this makes debt reduction an imperative (chart below).

A lot has been said and written about the individual fiscal measures and there is little point in rehashing it here (see the IFS analysis for more detailed insight). But a few things are noteworthy: Rachel Reeves did say a year ago that she would not be coming back for more tax revenue following the rise in employer NICs. But she did, and the largest single measure was the extension of a freeze on income tax thresholds from 2028-29 which is set to generate roughly half of the additional tax revenue predicted by 2030-31. Although Reeves did not raise marginal income tax rates, this freeze implies an increase in average income tax rates as earners are pulled into higher tax bands thanks to inflation, hurting the lower paid. There is also a political dimension: A general election must be held no later than summer 2029. In the absence of any recovery in popularity, the government will be going into an election campaign on a platform of higher effective taxes. It is unlikely to be a vote winner and it is a policy which may not survive contact with political reality.

Trying to put it in context

As my colleagues at NIESR noted in the wake of the Budget, it “locks in a high-tax, high-debt steady state in a world of low productivity growth and higher interest rates. Even the historically large tax share of GDP now planned is only just enough to stabilise – not reduce – a debt ratio stuck around 100 per cent of GDP for the foreseeable future … there was a notable lack of economic vision beyond clearing fiscal hurdles. Reforms to the triple lock, council tax, and VAT were pushed into the background while the Chancellor focused – justifiably – on meeting the fiscal rules.”

In other words, the Chancellor – like most of her predecessors – continued to dance around the elephant in the room, goaded on by a rabid commentariat in thrall to the economics of the 1980s. Either voters have to accept that they will have to stump up for the public services they say they want, or they will have to find alternatives. Over the past 40 years, successive governments have told the electorate that consumers are best placed to spend their own money and that they want to put more money back into their pockets. 

This is a laudable objective, but what governments failed to point out is that a smaller state means that voters will have to pay more out of their own money for certain services. More money in voters pockets means less goes to the NHS so if consumers want the same quality of service, they will have to pay more for private health cover. Implicitly, Reeves did drop hints in this direction in her Budget speech. But it is an unpopular message and if a government with a 148 seat majority in parliament is unable or unwilling to make the case, we should not hold our breath that we will be able to have an adult conversation about fiscal trade-offs any time soon.

Taxing times

Following Chancellor Rachel Reeves’ speech on 4 November, it appears that the government is considering breaking one of its manifesto pledges not to raise taxes on working people. There is considerable speculation that the Chancellor will announce a rise in income taxes on 26 November for the first time in 50 years (neither the basic nor the higher rate have been raised since 1975). This is far from a certainty. Indeed, the government will be taking an almighty risk: An unpopular government lagging in the polls does not lightly break such a key election promise. But if it does happen, it is imperative that the government uses the revenue to improve public services in order to fend off the electoral rise of Reform UK. Failure to do so may harm Labour’s chances at the next general election.

Tax choices are political as well as economic decisions. In many ways the government created a rod for its own back prior to the 2024 election by pledging not to “increase National Insurance, the basic, higher, or additional rates of Income Tax, or VAT.” History suggests it is very unwise to make such commitments when economic circumstances can change very quickly (think the GFC, Covid or the impact of the Russia-Ukraine war on oil prices). The pledge was thus an unwise political choice that is set to be reversed. Any tax-raising decisions later this month thus have to be viewed through the lens of politics, as well as economics.

The economic choices are clear enough: Raise as much revenue as possible while inflicting the least amount of damage to economic growth. The political choices are more difficult to navigate: Where should the burden of tax increases fall without damaging political support? Politicians would like to shift the burden of tax onto businesses wherever possible – after all, they do not vote (although they may be substantial political donors). However, having raised payroll taxes in the form of higher employer National Insurance Contributions and hiked the minimum wage in April 2025, scope for asking businesses to bear even higher costs is limited. Raising minimum wages has contributed to higher inflation in recent months, and there is evidence to suggest the labour market is losing momentum.

While voters clearly do not relish the prospect of higher taxes, they are the ultimate consumers of public services and will be required to pay in some form. In any case, much of the deterioration in public finances over the last five years can be attributed to government support during the Covid crisis and the subsequent energy price spike. As I pointed out in March 2020: “A question which has been put to me by non-economists is who is going to pay for all this largesse. In truth, we are – maybe not immediately, but in the longer run … Under normal circumstances, bond yields would be expected to rise sharply in anticipation of big increases in national debt, which would in turn imply a rising proportion of tax revenue being used to service debt. Governments would thus be expected to respond with fiscal tightening.”

What options are available to the Chancellor?

The Chancellor has two problems: In the short-term, she needs to raise additional revenue, but in the longer-term the tax system needs an overhaul – a topic which I have touched upon on numerous occasions in the past (here, for example). But the political cycle being what it is, the Chancellor will have to act to plug holes in the public finances sooner rather than later. In the last fiscal year, almost 79% of central government revenues were derived from just four tax heads – incomes (31%), VAT (20%), social contributions (18%) and corporates (10%). As a matter of expediency, it is these four areas which are most likely to be raised in order to generate significant sums.

I am indebted to my colleague, Ed Cornforth, for running the numbers through NiGEM – NIESR’s global macro model – to assess the economic consequences of various tax hikes, with the results summarised in this policy paper. The results suggest that raising income taxes would be the least distortionary policy action in terms of its short- and longer term impact on inflation, unemployment, GDP and interest rates. Raising VAT is pretty much a non-starter given its regressive implications, not to mention its near-term impact on inflation. Increasing corporate taxes depresses the economy’s potential growth rate by reducing investment, which ultimately reduces productivity and real wages and leads to higher unemployment. It is thus easy to understand why Chancellor Reeves would be tempted to increase income taxes – it is the least worst of the short-term options.

It is unlikely that all of the fiscal shortfall will be covered by income taxes alone. My NIESR colleagues calculate that in order that the government achieve its goal of balancing the current budget by fiscal year 2029-30, while ensuring an adequate buffer against unforeseen shocks, a fiscal tightening of at least £50bn will be required. According to the HMRC’s Ready Reckoner, achieving this solely through income tax hikes would require an increase of almost 5 percentage points in the basic and higher rates of income tax (currently 20% and 40% respectively) which would seem to be a political non-starter. A more balanced package comprising a 1pp rise in income taxes, employee NICs and inheritance duties, together with increases in various duties, could raise around £20bn. In other words, we can get almost half way there by pulling on some of the more obvious levers but this would still leave us a long way short. It is notable that while the Resolution Foundation’s creative proposal to increase income taxes by 2pp while compensating with a 2pp cut in employee NICs may dilute much of the political anger, it would offset much of the fiscal effect, rendering it less useful.

Of course the other option open to the Chancellor is spending cuts. But having set out a Comprehensive Spending Review as recently as June, it is difficult to imagine that the Chancellor will want to rip up her carefully crafted spending plans (though some cuts at the margin may be a possibility).

More radical options for tax reform

Among the areas open to scrutiny is the taxation of pensions. Currently, employee pension contributions receive income tax relief at the highest marginal rate which means that higher-rate taxpayers receive 40% relief, whereas basic-rate taxpayers receive only 20%. It is often suggested that this creates a series of perverse incentives, whereby those who are already better off gain the greatest benefit, while lower earners receive comparatively little encouragement to save for retirement. Reforming pension tax relief – such as moving to a single flat rate of relief – has long been proposed as a way to improve fairness and potentially raise revenue. Indeed the IFS estimates that limiting relief to a flat rate of 20% would generate an additional £22bn by 2029-30.

However, the IFS also points out that it would be unfair to give relief at 20% but impose a marginal tax of 40% on those whose retirement income pushes them into the higher tax bracket. Instead, it suggests that around £6 billion per year could be raised by introducing NICs on employer pension contributions, which are currently exempt. An alternative would be to align the tax treatment of contributions and withdrawals (e.g. pension income is taxed at 20%), or introduce a tapered system that balances fairness with fiscal sustainability (e.g. tapering tax relief at rates between 20% and 30% depending on incomes).

But such measures would serve only to introduce additional complexity into an already complicated tax system. Prior to the 2024 general election I suggested that one thing the incoming government might consider was a Royal Commission on tax reform to assess the proposals made in the 2010 Mirrlees Review. The main conclusions of the Review were that the tax system should raise revenue efficiently, minimising distortions to work, saving and investment decisions by avoiding piecemeal changes that create inconsistencies. Currently, it is quite the opposite: as Martin Wolf pointed out in the Financial Times recently, “the tax system is a mess”. But it may still not be too late to implement a reform plan, perhaps in conjunction with the modest tax hikes set out above. Indeed, it might be possible to sell a need for temporary tax hikes which will be at least partially reversed when the suggestions from a Royal Commission are implemented (admittedly, that would be a tough sell).

Last word

This is not the place to go into a detailed review of some of the areas that are ripe for reform, but a coherent look at property and inheritance taxes are clearly required. Motoring taxes and carbon emissions taxes are other areas of the system where an overhaul is necessary; it has always seemed inconsistent that motoring fuel duties have been frozen since 2011 at a time when governments have expressed their commitment to net zero. As the IFS has noted, if fuel duties had been uprated in line with RPI inflation since 2011, it would have an additional £17.4bn of revenues to play with.

The bottom line is that the current fiscal model has run out of road and it is time to think more seriously about what voters want government to deliver and how we can pay for it. As I have noted many times previously, the tax cutting policy introduced in the 1980s was viable in a world where the old age dependency ratio was stable, but it has risen sharply over the last 15 years and will continue to do so for at least the next 25. This suggests that it is time to bite the bullet on fiscal policy and have the grown-up conversation between government and voters that has been postponed for too long.