Britain’s budget choices are not as bad as the government says

The mood music from Britain’s new government about its first budget has been a funeral dirge. “There’s a budget coming in October and it’s going to be painful,” Sir Keir Starmer, the prime minister, warned in August. “The road ahead is steeper and harder than we expected,” said Rachel Reeves, the chancellor, at the Labour Party’s conference on September 23rd. A day later Sir Keir invoked “the iron law of properly funding policies”.

This barrage of misery has served a purpose. Labour wants voters to view the budget, which will take place on October 30th and almost certainly include tax rises, as proof of a grim economic inheritance from its Conservative predecessors. In July Ms Reeves claimed to have discovered a £22bn ($29bn; 0.8% of GDP) fiscal “black hole” in this year’s accounts.

The reality is more nuanced. The Tories did plenty to mute growth and muddle the public finances. But Ms Reeves has more wriggle room than she has let on. The constraints she faces on tax are largely self-imposed. Even the £22bn black hole is something of a mirage. Perhaps around half was truly unforeseeable: troubling cost overruns on the asylum system and more. But, as one-offs, these don’t affect Britain’s fiscal position much. The other half—pay bumps for public-sector workers—will have a fiscal impact but were no surprise.

So just how tough will Ms Reeves have it on October 30th? Britain’s main fiscal rule requires that government debt be projected to fall as a share of GDP in the fifth year of a five-year forecast from the Office for Budget Responsibility (OBR), an independent watchdog. Jeremy Hunt, Ms Reeves’s predecessor, left Britain with £8.9bn in “fiscal headroom”, the amount of borrowing permitted before the government violates its fiscal rules. Since then gilt yields have fallen, growth has been strong-ish and another fiscal year has passed, which rolls the five-year target on by another year. That should push Britain’s fiscal headroom up once the OBR updates its forecasts. Capital Economics, a consultancy, reckons it will hit £22bn.

With tweaks, that headroom could rise further still. One sensible move would be to exclude the Bank of England’s losses from quantitative easing from the definition of public debt used for the fiscal rules. Doing so would push headroom up by another £17bn, to £39bn (see chart), estimates Capital Economics. Another option is to exclude Labour’s new investment institutions—GB Energy and the National Wealth Fund—from debt calculations.

Practically, higher headroom means more space for the government to borrow. That raises a separate issue: can the market bear it? Nerves have jangled since the debacle of Liz Truss’s mini-budget in 2022. But a shift largely within Britain’s existing fiscal rules, without high inflation or a spat with the OBR, is unlikely to raise hackles. Even international economic bigwigs at the OECD and IMF have said that Britain’s fiscal framework inhibits productive investment. The bulk of any extra borrowing would need to be reserved for investment to stay within Ms Reeves’s secondary fiscal rule that day-to-day spending be in balance. That would accord with another bit of her conference speech: “Growth is the challenge and investment is the solution.”

Just borrowing more won’t suffice to balance the books, however. To stave off spending cuts that Mr Hunt had planned and to cover the public-sector pay rises that Ms Reeves agreed to in July, taxes will need to go up. Most straightforward would be to reverse Mr Hunt’s pre-election cuts to national insurance, a payroll tax: that would raise a little over £20bn annually.

Unfortunately, Ms Reeves has boxed herself in with her pre-election pledges not to raise income tax, national insurance, VAT or corporation tax. Nick Macpherson, a former mandarin, has said that if he were still at the Treasury: “I’d be endlessly trying to reopen the debate on the red lines.” There may be room to fudge a little. Fiddling with how national insurance is levied on pension contributions, which involves raising taxes technically paid by employers, could raise £9bn or so, reckons the Resolution Foundation, a think-tank.

The messier but more likely alternative is that Labour pulls together a bunch of smaller changes. Ms Reeves has already announced that the winter-fuel payments for pensioners will be means-tested. Labour’s voter base may be open to some options that the Conservatives shied away from, like raising fuel duty or abolishing some inheritance-tax reliefs. Ms Reeves is also eyeing capital-gains tax (CGT). Changes like removing the uplift at death (whereby a deceased person’s unrealised assets are reset to market value, removing any historical gains from the reach of the taxman) could raise a few billion.

Raising the main rate needs more care. Capital income is taxed less heavily than wage or dividend income in Britain; wanting to reduce that wedge is a sensible impulse. But dangers abound. Capital can be flighty; excessively high rates risk deterring investment. If investors see a CGT rise as unsustainably high, they may also hold off on realising gains until a future government lowers it, reducing any tax windfall.

Ms Reeves’s task on October 30th was never going to be easy. She wants to be a trusted custodian of the public purse and a bold enabler of growth. Labour’s own choices have made the job harder. ■

For more expert analysis of the biggest stories in Britain, sign up to Blighty, our weekly subscriber-only newsletter.