Everything Rachel Reeves could do to fix the economy

On 30 October, Rachel Reeves will announce the first Labour Budget since 2010. Though a momentous occasion for the party, the chancellor has warned the country that ”tough decisions” on tax and spending lie ahead. Reeves is boxed in by fiscal rules on one side, and an election pledge not to increase taxes on ‘working people' on the other. 

Reeves has already announced a tweak to her fiscal rules, freeing up more money for giveaways, but this will not be enough to prevent taxes from rising later this month. With capital gains tax (CGT), inheritance tax (IHT) and changes to tax relief on pension contributions under the spotlight, we set out what to expect from the 2024 Autumn Budget.

 

Is there any room for giveaways?

Labour, like their Conservative predecessors, have bound themselves by a set of fiscal rules. The first sets out that the day-to-day costs of government must be met by revenues – meaning that the government can only borrow to fund investment. But day-to-day running costs have ballooned. In July, Reeves warned that she had inherited a £22bn ‘black hole’ in public finances, driven largely by a lack of cash to fund higher public sector pay settlements and the cost of supporting asylum seekers.

The Office for Budget Responsibility (OBR) is expected to publish a review into the "adequacy” of information supplied by the previous government alongside its usual forecasts on Wednesday. Economists at the Institute for Fiscal Studies (IFS) think tank estimate that the government needs tens of billions of pounds just to honour public sector pay settlements and avoid spending cuts this year. 

Change the ‘fiscal rules’

The second fiscal rule states that debt must fall as a share of economic growth by the fifth year of the OBR's forecast. Thanks to an improving economic backdrop, Reeves would probably have found herself with up to £22bn of headroom under existing rules – a big increase on the £8.9bn Jeremy Hunt had in March, as the chart below shows. But in practice, her headroom will be even greater.

Last week, Reeves confirmed that she will tweak the measure of debt used in the second fiscal rule to place more emphasis on the impact of investment on potential growth and the supply side of the economy. The new gauge (rumoured to be ‘public sector net financial liabilities’) would provide a far broader measure of the public balance sheet, and could increase headroom by as much as £53bn a year by 2028-29.

Economists at the Institute for Fiscal Studies (IFS) think tank said that a new rule could give the government “greater incentives to invest in higher-quality projects and to better manage and maintain its assets”. This approach also has the support of former Bank of England governor, Mark Carney, who argued that “if government money is being spent to build or buy an asset on behalf of the nation, it is only right that its value is captured in the definitions of national debt”. 

Though changes to the debt rule will allow for more investment, tax hikes will still be needed to cover higher day-to-day spending. Analysts at Capital Economics expect Reeves to raise taxes later this month, pocketing any extra headroom for later in her term. This would probably be politically expedient, too: “it is appealing to raise taxes when they can be easily blamed on the previous government”, they added.

Best ways to raise taxes 

Since Labour has already ruled out raising taxes on ‘working people’, the chancellor is left with a relatively narrow range of options. These are the most likely candidates for tax hikes and how much they could raise each year: 

Employer national insurance contributions: £17bn 

Increasing employer national insurance contributions would allow Reeves to stick to the letter of her pledge not to increase taxes on working people – if not quite the spirit. Reeves could raise around £17bn from a 2 percentage point rise in employer national insurance contributions, according to HMRC. 

Despite earlier speculation, Reeves has reportedly rejected the idea of levying NI on employers’ pension contributions. The Resolution Foundation think tank estimated that this measure could have raised £12bn a year, but critics warned that it risked reducing pension savings.

Freezing income tax thresholds again: £7bn

The Conservative party froze income tax thresholds and the personal allowance until 2028. Calculations from the Resolution Foundation suggest that Labour could raise £7bn by 2029-30 if they extend the freeze for a further two years. 

Freezing thresholds can be a relatively uncontroversial way of increasing revenues: as incomes rise in line with inflation, people are dragged into higher tax brackets, paying more tax. This means that the government can raise significant sums without having to announce an unpopular tax hike. 

But it could prove politically difficult for Reeves this year. The plan would sit uneasily with Labour’s pledge not to increase taxes on working people, while the party were critical of threshold freezes whilst in opposition. Reeves argued last year that stealthy tax increases under the Conservatives had “picked the pockets of working people”. 

Capital gains tax (CGT): <£10bn 

The government could raise substantial sums by changing capital gains rates – but economists can’t agree on how much. One study found that equalising capital gains and income tax rates could raise £16bn. Others are far more pessimistic, suggesting that behavioural changes could end up reducing revenues. 

Economists at Goldman Sachs expect a ‘relatively modest increase’ in CGT in the Budget, raising “at most a few billion a year”. According to the IFS, smaller measures such as abolishing business assets disposal and ending capital gains forgiveness at death could raise a further £1.5bn a year each. 

Inheritance tax (IHT): £4bn 

Changes to IHT also look likely in the 2024 Autumn Budget. Scrapping the residence nil-rate band could raise around £1.8bn a year, while capping agricultural and business reliefs and bringing defined-contribution pension pots into estates could raise a further £2.2bn. 

Pensions taxation: £5bn 

A flat rate of tax relief on pension contributions of 30 per cent could net the chancellor £3bn a year – although far more (£15bn) could potentially be raised by restricting it to 20 per cent. Reducing the allowance on tax-free pension withdrawals from £268,000 to £100,000 would raise a further £2bn. 

Other measures: £3bn

The government has also refused to rule out changes to the single-person council tax discount, which costs around £3bn a year. Increasing band F, G and H multipliers by 50 per cent could raise a similar amount. 

What it means for the economy and gilt yields

Despite the raft of possible measures, economists do not expect the government’s fiscal plans to have a huge impact on the economy. Analysts at Capital Economics think that even if the government does raise taxes by more than expected, lower interest rates should keep the economy on track next year. The risks of an “investment bonanza” seem equally limited thanks to the government’s fiscal rules. 

Sanjay Raja, chief UK economist at Deutsche Bank thinks that “despite the merits of boosting investment, the chancellor will almost certainly be aware that large borrowing sprees won't be risk-free”. As the chart above shows, the 10-year gilt yield has risen from 3.6 per cent in mid-September to more than 4.2 per cent today – the highest since July. This backdrop could leave the chancellor wary of making any changes that could be seen as compromising the integrity of  Labour's fiscal rules.

 

Will it work?

But there is little risk of Reeves triggering a Truss-style market meltdown. In March, Hunt was accused of ‘gaming’ his own fiscal rules by relying on forecasts based on implausible tax and spending plans. He saw no real bond market pushback. 

Analysts at Pantheon Macroeconomics point out that bond market movements have also been influenced by the rising oil price and changes to US interest rate expectations this month. This suggests that gilt markets will prove less sensitive to changes to fiscal rules than recent ructions imply– and could even greet higher investment spending as good news. 

This does not mean the Budget will meet a warm reception. By ruling out changes to the UK’s major taxes (see chart below), Labour finds itself forced to raise revenues through several piecemeal measures. It is said that the art of taxation is plucking the goose to get as many feathers with as little hissing as possible. But more policy changes will probably mean more hissing next week.