There are good economic reasons for Rachel Reeves to raise taxes

7 min read30 October

Nobody likes paying more, but there are good economic as well as political reasons for Rachel Reeves to raise taxes in the Budget, argues Tim Leunig

It is hard to recall, but this government got off to a good start. We saw Ed Miliband sign off new investment in solar and onshore wind, while Angela Rayner set about boosting housing investment by increasing targets. Since then things have gone less well, meaning the Budget will be seen as a relaunch as much as a budget. That is a shame, because this Budget is important in its own right.

Labour’s manifesto promised no return to austerity. That must surely mean that spending on public services maintains its share of national income. A growing population requires more police, courts and prisons, as well as many other public services. Rising private-sector earnings must be matched if we are to recruit teachers, doctors and so on. The Institute for Fiscal Studies (IFS) reports that taxes must rise by £25bn a year to maintain public services as a share of national income.

Big tax rises now will restore credibility, and reduce the cost of borrowing. That saves every single person in the country money

Politics means that taxes must rise by more than this. Take poverty, for example. The way the ‘two child’ benefit rule works means that the number of children living in poverty will rise each year this Parliament unless something changes. While the Conservatives were happy to fight the last election against the backdrop of an ever rising number of children growing up poor, the Labour Party stands for something different. There is no chance that Labour will tolerate rising and record numbers of children in poverty. More money must be found. That means taxes have to rise – you shouldn’t borrow to spend money on welfare.

The NHS is part of the Labour Party’s DNA. It wants an NHS the country can rely on and be proud of. That is what people expect of a Labour government. Just “avoiding a return to austerity” is not good enough. Given the backlog and the absurdly tight inherited future spending plans, the government will have to spend more money on the NHS, as well as undertaking sensible reforms. Again, more spending means more taxes.

All this means that we should not be surprised that the Financial Times reports that “Treasury sources” say that the Chancellor is looking at £40bn of tax rises.

No one likes higher taxes, but there are many reasons to support them in this Budget. The first and most obvious is political – if taxes are going to rise, best to get it done early in a Parliament.

The second reason is financial. Ruling out so many tax rises in the manifesto created a credibility problem. Money markets wondered whether the government would be able to raise tax revenues significantly. Those worries pushed UK gilts rates up towards the end of the summer, so that we now pay significantly more than Germany to borrow money. We are not quite back to Kwasi Kwarteng interest rate levels, but we are not far off. Big tax rises now will restore credibility, and reduce the cost of borrowing. That saves every single person in the country money. Gilt yields fell a touch on the day the FT story came out, and both the FTSE 100 and FT All-Share indexes rose. Markets, in turns out, are OK with big tax rises.

Third, a big rise in tax will cut the interest rates we all pay as individuals. With inflation now below target, the Bank of England is bound to cut interest rates in any case, but a disinflationary Budget means, as sure as night follows day, that the Bank will cut interest rates more quickly and to lower levels than if the government plays fast and loose with the nation’s finances.

Lower interest rates reduce monthly mortgage payments, making people better able to pay higher tax bills, as well as supporting local economies with greater spending. They also make it likely that the pound sheds its recent gains, helping exporters. Indeed, the pound fell when the FT story appeared.

Fourth, lower interest rates cut the cost of businesses’ investing, which means United Kingdom business investment will rise. That will in turn raise productivity. LSE professor – and now adviser to the Chancellor – John Van Reenen has remarked: “The UK productivity problem can be summed up in three words: investment, investment and investment.” Productivity growth, in turn, is the surest route to both higher wages, higher tax returns – and re-election.

The final reason for re-establishing fiscal credibility via big tax rises is that – paradoxically – it allows the Chancellor to borrow more for the right things. Rachel Reeves is correct to commit not to borrow for current spending, but the rule saying that debt must fall within five years is not sensible, because it takes no account of assets. As it stands, the rule could stop the government from making much needed public investments.

That said, the Chancellor must not go too far the other way. Not all public investment or assets are equal. Two aspects matter. The first is whether the proposed investment will yield a tangible, predictable financial return to the government. Ultimately government debt needs to be repaid, and that requires a revenue stream. It is possible for a government to build a bridge to nowhere to please a particular lobby group. That ‘asset’ would, in reality, be a liability, as it would need maintaining. It is equally possible for a government to lose all control of costs, so that a project ceases to offer a reasonable return. The way that HS2 costs have spiralled out of control is a blunder of government that will be discussed for many years. But government investment can generate decent direct returns. The Elizabeth line now boasts the second highest number of passengers of any rail franchise in the country, despite not going to many places.

As well as thinking about direct returns, the government should also consider whether government investment will crowd out or crowd in the private sector. Either is possible. As an example, social housing might crowd out market housing, given our tightly controlled planning system. There is, of course, a social justice case for more social housing, but investing more in social housing might just replace private investment, leaving total investment unaffected. Public investment can do the opposite, and crowd in private investment. The classic case is all those offices and flats in Docklands that would not have been built without the government building the Docklands Light Railway and later the Jubilee line. Good transport links gave the private sector the confidence to invest in these locations, creating both a short-term construction boom and allowing our financial industry to grow dramatically. The government – and the Office for Budget Responsibility – need to establish a methodology to work out which forms of government investment will lead to crowding in and out, and to include those costs and benefits accordingly.

There is, therefore, a strong economic case for higher taxes. Increased credibility in the markets will cut the cost of the government debt. Higher taxes will lead the Bank of England to cut interest rates, helping households and making exports more competitive. Finally, lower interest rates will increase private sector investment rates, and allow the government to borrow more to invest. Both will raise the rate of growth and our living standards. No one likes higher taxes – but this year they are the sensible option.

Professor Tim Leunig is a senior policy fellow at The Productivity Institute, and former economic adviser to Rishi Sunak as chancellor

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