ROI-Will UK Labour Party have the courage to become even more unpopular? – Mike Peacock

By Mike Peacock

LONDON, Nov 25 (Reuters) - British finance minister Rachel Reeves, who faces a make-or-break budget this week, should view her Labour government’s deep unpopularity as a gift. With more than three years remaining before the party must hold an election, there may be little to lose by acting boldly now – and potentially much to gain.

The ruling Labour party commands less than 20% support in opinion polls after a landslide election win in 2024. Whatever it is selling, the British public isn't buying.

But unpopularity could be liberating.

Reeves is set to present the heavily contested autumn budget on Wednesday. Building in more fiscal space would require politically toxic tax rises and spending cuts. But it would also allow the government to take a strategic approach to increasing economic growth, giving it a fighting chance of stacking up some wins before voters return to the polls for the next general election.

Such an approach would also present a coherent plan to bond investors, which ultimately could lower borrowing costs and a debt interest bill that tops 100 billion pounds a year. And it could help the Labour Party present something it has lacked in recent years – a narrative about its long-term vision.

WHAT TO DO?

Reeves faces two enormous challenges of the government's own making.

First, there was an election pledge not to increase income tax rates, national insurance or VAT, which collectively account for three-quarters of Britain’s tax take. And second, there’s leaving the government with only 10 billion pounds of budget headroom under the current fiscal rule. In a 2.5-trillion-pound economy, that’s essentially a rounding error.

It gets worse. (And I’m not referring to the weeks of budget leaks and counter-leaks that have left the government looking rudderless.)

A downgrade in productivity forecasts by the Office for Budget Responsibility, Britain's fiscal watchdog, and government policy reversals mean Reeves may now have to raise something like 20 billion pounds just to maintain her current fiscal ground.

Building a more durable buffer – 25 billion pounds or more would equate to 1% of GDP – and sustaining the investment boost she initiated last year would require the government to come up with roughly 40 billion pounds from spending cuts and tax rises.

So what are her options?

On the spending side of the equation, the government will clearly need to tackle a welfare system that swallows almost a quarter of government expenditures annually.

One source of savings may be addressing ever-expanding retiree benefits. That would be very unpopular. But the “triple lock,” whereby the state pension rises annually by the highest of a 2.5% floor, the prevailing rate of inflation, or the increase in average earnings, is viewed by most economists as unsustainable.

On the revenue side, things are more complicated. Reeves appeared to be touting an income tax rise a few weeks ago – the first in 50 years – but that idea now appears to have been dropped.

That could be a mistake. A two-percentage-point increase across tax bands could raise about 14 billion pounds a year. And the National Institute of Economic Research calculates that of the major tax rises under consideration, an income tax hike would deliver the smallest hit to growth before the deadline for the next general election while also producing a predictable revenue stream.

What’s now more likely is an extension of the freeze on income tax thresholds, meaning billions may be raised by a stealth tax rise as workers get dragged into higher tax bands as their nominal wages increase. From an economics perspective, that’s hardly the most efficient way to raise taxes.

Value-added tax – a sales tax – will almost certainly not be increased as it could push sticky inflation up further, curbing the Bank of England’s scope to deliver growth-boosting interest rate cuts.

That leaves a mix of different minor taxes, targeting items such as gambling, pension savings, electric cars and expensive properties. That route would deliver a less certain revenue stream and more doubt about the potential impact on growth.

SIMPLIFY, SIMPLIFY, SIMPLIFY

Another option would be simplifying Britain’s Byzantine tax code. That would convey a sense of strategic vision even if the results take time to arrive.

“We haven't, seen a chancellor take a strategic look at the tax system for almost 40 years,” former Bank of England Governor Mervyn King told Sky News recently. "It's been one kind of tinkering after another and that's created a mess - an excessively complex one."

British corporation tax was rated as one of the least competitive in the world because of its complexity, tax expert Dan Neidle told parliament's cross-party Treasury Committee recently. He noted that a VAT exemption for small businesses with annual revenue below 90,000 pounds meant that going above that threshold results in a 20% tax hit.

The income tax structure isn’t any better. It slaps an effective marginal tax rate above 60% on anyone earning 100,000-125,000 pounds, while those below that pay a rate in the mid-40s.

These examples create perverse incentives: to work less, grow less, invest less.

Of course, reforming some of these measures could be politically unpopular, as would trimming retiree benefits or breaking pledges around income taxes.

But given the government’s current polling and the markets' likely response should Reeves balk at meaningful budget fixes, a bold move may end up being the safer bet.

(The views expressed here are those of Mike Peacock, the former head of communications at the Bank of England and a former senior editor at Reuters)

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