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.

A rough start with worse to come

Keir Starmer’s Labour government took office a year ago following an overwhelming election victory that consigned an unpopular Conservative government to history. I did, however, warn that Labour’s victory owed less to its own popularity and more to the electorate’s desire for change. As I noted at the time: “This makes it all the more imperative that Starmer’s government gets the big things right quickly. Making voters lives better is the one thing that will raise the chances of a second term in office – a second term that will undoubtedly be required to properly fix many of the things in the economy that require improvement.”

Fiscal challenges and policy U-turns

Measured against this yardstick, the government is failing to meet its objectives and there is common agreement that it does not have a clearly defined philosophy. Economic policy has largely been focused on tackling the UK’s mounting fiscal burden. The Chancellor, Rachel Reeves, claimed in summer 2024 that the situation was worse than Labour imagined before taking office, though as the Institute for Government has noted: “the truth is that most of the tough fiscal choices that this government faced were well known before the election – politicians from both main parties simply chose to ignore them.” Reeves claimed that unfunded spending commitments made by the previous Conservative government resulted in a £22bn “black hole” in public finances (around 0.8% of GDP). While it is true that a Treasury audit pointed to a departmental overspend in fiscal year 2024-25 of £21.9bn, almost half of this arose from the current government’s discretionary decision to accept recommendations for public sector pay awards which were higher than those factored in by the Tories. Nor has the £22bn figure been endorsed by the OBR, which suggested that the previous government’s unannounced policy commitments were worth around £9.5bn.

Hemmed in by its manifesto commitment not to raise taxes on “working people”, the Chancellor was forced to find some measures to show the government’s commitment to fiscal rectitude. But the proposals put forward by Reeves have been poorly presented, with the result that the government has backtracked on policy announcements in the face of opposition. A case in point was the plan to limit the Winter Fuel Allowance to only the poorest pensioners. The payment was originally introduced in 1997 as a universal benefit but the incoming Labour government surprisingly announced in 2024 that it would be converted to a means-tested benefit. This generated a huge wave of criticism and was cited as one of the reasons why Labour performed so poorly in the May local elections and prompted a policy U-turn shortly afterwards. 

For all the political capital which was squandered by the policy, it was only expected to save £1.4bn of fiscal outlays, and the policy reversal, which raises the income threshold for the benefit, will now only save around £0.45bn – a trivial amount in UK fiscal terms (see chart above). Indeed, fiscal data for the first ten months of Labour’s tenure show that borrowing has risen by £33bn (around 1.1% of GDP) versus the corresponding period a year earlier.

Similarly, the government was forced this week to significantly water down its planned reform of the welfare system in the face of fierce opposition from backbench Labour MPs. Here, too, the fiscal savings resulting from tightening access to welfare payments are relatively small in the grand scheme of things, with an estimated saving of £5.5bn by fiscal 2029-30. As was the case with the Winter Fuel Allowance, a huge amount of political capital was risked to achieve a small monetary saving. This has raised questions about the government’s political acumen and has increasingly called the prime minister’s authority into question. While this is the normal response of a commentariat which likes nothing better than to poke holes in the shortcomings of the government of the day, it is increasingly clear that Starmer’s administration has failed to regenerate the feelgood factor. To the extent that the government is going to need a second term to address the deep-seated economic problems facing the economy, the fact that Labour now trails Nigel Farage’s Reform UK party in the polls should act as an urgent wakeup call (see chart below).

Hard to see how taxes cannot rise

Matters might well get worse before they get better. Indeed, there is increasing speculation that the government will be forced to raise taxes in the autumn, despite the manifesto commitment not to do so. The howls of protest from opposition political parties, and perhaps even from backbench Labour MPs, will be predictably loud, but in truth the government is out of fiscal options and has very little headroom to ensure that its fiscal rules can be met over the course of this parliament. Public services are stretched and the electorate has noticed. The NHS remains under huge pressure, and although there has been a small decline in waiting lists for treatment in the past 12 months, public dissatisfaction with the NHS continues to hit new highs (see chart below). Nor has the abolition of NHS England gone down well with medical professionals. The prime minister sold it as a way of increasing efficiency by reducing the degree of centralisation: Insiders see it as a way to cut NHS jobs. Equally importantly, the criminal justice system is operating with no spare capacity, to the point at which the government even experimented with the early release of prisoners to alleviate the strain – a policy which is unpopular with the public.

And then there is defence spending. The government plans to raise it to 2.5% of GDP by 2027 (2024: 2.3%) and has ambitions to increase it to 3% in the next parliament. NATO is seeking agreement from members to raise it to 5% by 2035, comprised of 3.5% under the current core definition with a supplementary 1.5% allocated to critical infrastructure protection. The uplift in 2027 will be financed by a reduction in the overseas aid budget but it is hard to conceive that any further increase can be achieved without raising taxes. A near-doubling of defence spending, to 5% of GDP, would take it to its highest level since the mid-1950s (see chart below). Faced with an ageing population which will stretch the NHS budget, and a sluggish productivity performance which continues to hold back growth, this government – and the next one – will have to make some very hard choices about how to spend their increasingly limited fiscal resources.

The government needs to improve its performance – and fast

Whether Starmer will be the prime minister beyond the next election remains to be seen. He has defied the doubters before, and is not someone who should be underestimated, but his personal popularity ratings are not high. In the wake of the recent policy U-turns, his net approval rating has dropped to -43% with mounting concern that he has responded to the electoral tactics of Reform UK rather than set the agenda on his terms. Starmer’s government has endured a rocky start and needs to outline an agenda which voters can buy into. Failure to do so in the second year of this government will merely raise the risk that Nigel Farage and his band of upstarts could come close to getting their hands on the levers of power in 2029.

As was the case with Labour’s big win in 2024, voters do not have to buy into Reform UK’s policies to reward them at the ballot box. They just need to believe that the status quo is failing, and that it is time to try something different. It may be four years until the next election, and the electorate may eventually forgive Labour for their rocky start, but Starmer and his team cannot afford another year like the last one if they are to win a second term.

Think outside the fiscal box

Fiscal issues continue to dominate the UK economic agenda with last week’s budget prompting huge debate as it attempted to repair some of the damage done by the Truss-Kwarteng car-crash mini budget in September. Not all of the deterioration in the fiscal position can be attributed to Truss’s disastrously brief tenure. Although the latest plan suggests that the government will borrow an additional £306bn by fiscal year 2026-27 compared to the March budget, a large portion of this reflects the measures designed to shield households from the full impact of the rise in energy bills (£37.6bn over the next two years). In this sense, part of the deterioration reflects an attempt to do the right thing by taxpayers. 

Higher debt interest payments account for roughly two-thirds of the increase in borrowing. This is only partly related to the market reaction to the disastrous mini budget. It is much more the result of higher interest rates in response to inflation at four-decade highs. This in turn is the result of both domestic monetary policy decisions, resulting from Bank of England actions to raise interest rates, and global actions as central banks around the world scramble to tighten policy. Nonetheless, it is incongruous that the UK government has implemented a tighter fiscal stance which is partly the result of tighter monetary conditions. Any fears that fiscal dominance is a theme in the UK policy environment can be set aside for now. 

The government did attempt to offset some of the fiscal damage resulting from these two factors by introducing a series of measures to close the gap. Whilst borrowing is higher than projected nine months ago, it is less than would be the case had not the government also implemented measures that by fiscal 2027-28 imply a fiscal tightening of £54.9bn, which translates into a fiscal contraction equivalent to 0.5% of GDP for each of the next five years. Spending cuts account for £30bn of the measures, although these are not scheduled to kick in until after the next election, whilst the remainder is derived from higher tax revenues (chart). 

There is an important political dimension to the latest budget plans. The fact that spending cuts only take effect in two years’ time in effect mean that the government is setting an elephant trap for the next government. If Labour win the election, which is scheduled no later than January 2025 and which seems likely on the basis of recent polling evidence, they will have to decide whether to go along with the current government’s fiscal plans or take a risk with new plans of their own, having been a major critic of the austerity policies in place since 2010. If the Tories win … well that’s a bridge they will cross when they come to it.

What is the goal of fiscal policy?

All of this leads to the real question: What exactly is the goal of fiscal policy? In recent weeks the debate has been all about the ideological split within the Conservative Party with supporters of a big state pitted against those advocating a small state, and there is a sense that the latter group is very much on the back foot. Last week’s efforts were clearly aimed at getting the markets back onside following the September shenanigans. Whilst it is important not to alienate one’s creditor, there was a nagging sense that too much emphasis was placed on placating markets. The budget balance cannot simply be an end in itself.

This raises the question of how much fiscal space the UK has and how well it stacks up against comparable economies. Conventionally, the degree of fiscal space is determined by the level of debt which markets believe an economy can carry without jeopardising the overall economic and fiscal position. It is true that UK debt gross debt levels are high – 97% of GDP at the end of fiscal 2021-22, rising to a peak of around 107% by early 2024 on the basis of the OBR’s forecast. Looking across Europe, however, the likes of Spain, France and Italy all have higher debt ratios (118%, 113% and 150% respectively) and none of them issue debt in a currency whose issuance they control. There is not the same debate about the need to wear the fiscal hairshirt in these countries, despite a worse fiscal position. Fear of the markets is currently the dominant theme of British fiscal policy rather than a coherent attempt to use policy in a more strategic sense.

What should policy be doing?

Successive governments have failed to have a grown-up debate about appropriate levels of tax. The demographic dividend that allowed the Thatcherite Tory party to cut taxes has ceased to be a tailwind and is now beginning to act as a fiscal headwind. Whilst it has long been said that the British electorate wants Scandinavian-level public services whist paying US-level taxes, it is currently getting neither (almost the opposite, in fact). Boris Johnson’s levelling-up agenda has been consigned to the dustbin and redistribution is still a dirty word in many areas of government.

Whilst Truss’s highly regressive fiscal plans have been found wanting, we are not yet at the stage where we are talking about what different things we might want fiscal policy to do. If we are serious about a transition to a green economy, for example, a big public investment in this area might pay dividends. I have also long advocated investment in making the economy fit to cope with climate change – again, government can play a role. However, we have missed our chance to use the lowest interest rates in history to fund such investment. But even if the government does not want to do any of these things, taxes will have to rise in order to provide the levels of public services that people have come to expect. In order to do so, we need to start thinking outside the box on taxes.

Governments over the years have tinkered with income and corporate taxes as the main areas of focus. I have in the past suggested that wealth taxes are an area that should at least be looked at more closely. Tax Justice UK, a lobby group which advocates for a “sustainable, fair and effective tax system” has suggested a number of tax loopholes which could be closed and in the process raise substantial revenue. Amongst the measures it proposes are equalizing capital gains with income tax rates, raising up to £14 bn a year (a measure which was originally championed by the Office of Tax Simplification). Extending national insurance to investment income could raise a further £8.6 bn a year. In all, it has identified measures which could generate an additional annual £37bn of income.

The bottom line is that there is no obvious need to squeeze spending quite as hard as the government outlined last week. Austerity was a bad policy in 2010. It is an even worse response today, with public services cut to the bone in many areas. Whilst there are many who argue that this is all to do with Brexit, it is not. We are at a point where demographics have collided with a low productivity economy to leave the government scrambling to provide a fix. Brexit is not helping, of course, since it will act to depress growth in the longer term and widen the budget gap. But in order to tackle the problems, we need to get away from the sterile discussion about further raising income or corporate taxes. It is about the need for a fundamental reform of the tax system. 

Farewell Liz, we barely knew ye

It is becoming increasingly difficult to know where to start in describing the political implosion at the heart of Westminster. A catastrophically-timed mini budget which attempted to kick-start growth by cutting taxes has proven to be a catalyst for a collapse of the Conservative government – perhaps even the party itself. In the last week alone, we have seen the departure of the third Chancellor since July (we are now onto our fourth in the shape of Jeremy Hunt) a second Home Secretary and we are now about to have the third prime minister in less than two months. Fans of political fiction could never have dreamed that they would be able to watch such drama unfold in real-time. It would be funny if it were not so serious.

How did it come to this?

Historians will undoubtedly have a field day in analysing Liz Truss’s shortest prime ministerial tenure on record. They will likely conclude that the Tory party implosion was a long time in the making. Tempting though it is to date the start of the rot to the Brexit campaign in 2016, the split within the Conservative party on the twin questions of Europe and the role of free markets in the economy – both of which played a key role in the recent shenanigans – dates back to at least the 1970s. More recently, the huge antipathy towards the EU demonstrated by large parts of the Tory party during John Major’s tenure as PM in the 1990s never quite spilled over into the mainstream at the time but it did poison the well. We have since been drinking from it for too long.

Undoubtedly, the Brexit campaign was an accelerant in the process. One of the potential benefits that Brexit offered was the chance for the UK to revamp its economic model – a deregulated model, free from the perceived constraints of the EU. This was never a realistic option: Putting up barriers to trade with the UK’s main trading partners could never be compensated for by trade with other nations. As the howls from small companies dependent on exports became louder it was increasingly clear that the economic costs of Brexit were mounting. Undaunted, the Truss administration doubled down with a policy of unfunded tax cuts that in their view would unleash the UK’s growth potential. We should perhaps not have been too surprised given that both Truss and Kwasi Kwarteng were authors of the infamous book Britannia Unchained which argued that Britain suffered from “a bloated state, high taxes and excessive regulation." It went on to suggest that “The British are among the worst idlers in the world. We work among the lowest hours, we retire early and our productivity is poor. Whereas Indian children aspire to be doctors or businessmen, the British are more interested in football and pop music."

When it came to putting the policy into practice, markets understandably took fright. Big, unfunded tax cuts at a time of slowing growth and rising interest rates were never going to fly. Had the policy been introduced more stealthily, it is possible that the Truss government could have made more progress towards its goals. It might have given Truss more time in office. But a big bang approach was the wrong strategy at the wrong time. With the Tories having warned for years that the economic plans of the Labour opposition would result in markets taking fright at eye-wateringly high public deficits, it is ironic that it took a Tory government to blow a huge hole in public finances and spook the markets. The likelihood that a UK government will attempt a similar policy of gambling with tax cuts to boost growth in the near future is low. The Singapore-on-Thames model espoused by many Brexiteers looks dead in the water.

It is also worth noting in passing that the MMT model of public finances does not come out of this episode unscathed. As I pointed out in 2019, “whilst it is true that governments will always be able to repay their local currency debt, it does not justify continually expanding the deficit without limit. In what can be thought of as the ‘when you’re in a hole, stop digging’ theory, governments have to be aware of the extent to which there will always be willing buyers of debt. If one government expands its deficit without limit but another is more prudent, bond investors will always favour the more prudent debt issuer.” If there is any silver lining to the clouds of recent weeks, it is that governments have been made aware of the existence of the budget constraint that proponents of MMT told us did not exist.

What happens now?

We should be in little doubt that the Conservative Party’s economic strategy lies in ruins. Announcing a radical tax-cutting policy, only to be forced to backtrack under market pressure, has blown the government’s credibility. The markets are thus likely to continue to demand a risk premium to hold UK assets for some time to come (memorably described by the economist Dario Perkins as the “moron premium”). This has raised howls of anguish in certain quarters that UK economic policy will increasingly be subject to market approval. But it did not have to be this way. So long as the UK continued to respect the domestic constraints imposed on policy actions by the OBR, the Civil Service and the Bank of England, markets would probably have continued to fund the UK’s mounting fiscal and current account deficits. Sacking the Permanent Secretary to the Treasury because he did not buy into Kwarteng’s plans; ignoring the OBR’s offer to assess the mini budget and calling the independent BoE’s mandate into question served to undermine trust in the UK’s solid institutional base. No longer can the UK rely on the kindness of strangers: It will come at a price.

The fiscal austerity unleashed under David Cameron dramatically hollowed out public services to the point that by 2019 their performance in many instances was already worse than in 2010. The hit resulting from the Covid pandemic has pushed many of them over the edge (see chart below). In its latest Performance Tracker, the Institute for Government notes “these are not isolated problems in individual services, but interconnected structural failures – particularly in the health and care and criminal justice systems … Governments since 2010 may have been seeking efficiency over resilience but achieved neither.” 

Viewed in this light the policy of cutting taxes was always a non-starter. It would become impossible to deliver even basic public services by lowering taxes, and the breathtaking inequity of the strategy beggars belief: Those whose taxes were being cut were not those most reliant on the crumbling public services infrastructure. As it is, the government is likely to have to find more savings. Having rolled back much of its plan to cut taxes, with the proposal to cut corporate and income taxes now off the table, the government has maintained that it will not raise NICs which leaves an £18bn hole in the public finances on a 5-year horizon (0.8% of GDP). This is not a propitious inheritance for the new PM, whoever they may be.

On that note, the UK continues its descent into an irony-free political zone with news that Boris Johnson has considerable support amongst Tory MPs should he wish to return to 10 Downing Street. This is the same Johnson that MPs turfed out over the summer due to his chaotic government style. Were he to make a return, and it is far from certain that he will, this could be the straw that breaks the camel’s back and splits the Conservative Party, with many MPs potentially siding with the opposition to trigger a general election. In any case, if he has any sense Johnson will steer well clear of the premiership, for he cannot possibly hope to gain. The economic situation is far worse even than when he left office and his style of government is not suited to the austerity which is increasingly demanded by markets (indeed markets took fright on the news that Johnson was in the frame). He cannot play the Brexit card as he did in 2019 and he faces a far more credible Labour leader in Keir Starmer than he did when up against Jeremy Corbyn.

Over the past 50-odd years the UK has faced down a series of economic crises with each one portending an end to the face of Britain as we knew it. Invariably, however, it rebounded and demonstrated a resilience that surprised the doomsayers. But this time, as they say, is different. The UK has not faced a political crisis such as the current one in well over 60 years (since the Suez Crisis of 1956). What makes this worse than any other episode in living memory is that the country’s institutional framework is dramatically impaired after years of neglectful governance which will reduce the UK’s resilience in the face of shocks. In 1975, a Wall Street Journal  editorial observed the reduced state of the British economy and concluded ‘Goodbye, Great Britain, it was nice knowing you.’ The events of recent weeks certainly feel as though something has been broken that will not easily be put back together again.