Britain’s next government will almost certainly need to raise taxes and make unwelcome spending choices even if this week’s budget update from finance minister Jeremy Hunt presents a superficially brighter picture.
The country is facing long-term headwinds from an ageing population, chronically weak growth and overstretched public services, amplified by a surge in borrowing costs.
While many of these challenges are common to other European countries, Britain’s near-term growth outlook is especially weak, interest rates have risen more sharply and aspects of its budget planning process make it hard to take longer term decisions and discourage more prudent policies.
With an election due no later than January 2025, neither the opposition Labour Party, which is currently well ahead in opinion polls, nor Prime Minister Rishi Sunak’s Conservatives want to talk about higher taxes.
But tax rises will be very hard to avoid for whichever party forms the next government, says James Smith, a former Bank of England economist who is research director at the Resolution Foundation, which focuses on issues affecting low and middle earners.
“Neither party wants to have that conversation openly. They don’t want to be the party of raising taxes. But it’s inevitable if you want to address the serious problem that we have in terms of public services,” Smith said.
Britain’s tax burden has already risen sharply. Tax revenue this financial year as a share of gross domestic product is forecast to reach 37%, according to the government’s budget office, up from around 33% before the pandemic and the highest since 1948.
However, by European standards the country’s tax rate is low. Data for 2021 from the Organisation for Economic Co-operation and Development showed Britain was the lowest among major European countries, well below France’s 45% or Germany’s 40%.
Most of the recent increase has come through “fiscal drag”, where exemption thresholds for income tax and other taxes have not risen in line with wages or inflation, which hit a 41-year high last year.
With inflation set to fall, Britain’s next government will gain less from this comparatively easy option.
For earlier governments, the main way to increase tax levels has been to raise the rate of national insurance – a payroll tax paid by employers and employees – and, in the Conservatives’ case, higher value-added tax.
The Institute for Fiscal Studies (IFS) and the Resolution Foundation both say a future government should look at more ways to tax wealth in addition to income. Residential property taxes, for example, are low compared with many other countries and only loosely related to current property values.
Slowing Growth
Tax has risen as a share of GDP partly because Britain’s economy has grown more slowly since the 2008 financial crisis.
Annual GDP growth averaged 2.0% from 2010-2019, compared with 3.0% from 1997-2007. The International Monetary Fund forecasts British growth in 2024 will be the weakest of any major advanced economy.
Alongside weak growth, government debt has reached its highest since the early 1960s, at 98% of GDP – 2.6 trillion pounds ($3.2 trillion) – from 36% on the eve of the financial crisis, a level that leaves it mid-table compared with other large, rich economies.
While British governments typically run roughly balanced budgets for day-to-day spending during normal times, they have made little progress repaying the surge in borrowing during the financial crisis and the COVID-19 pandemic.
And unlike in the decade after the financial crisis, borrowing costs are no longer near zero.
Interest rates for new 10-year government borrowing are above 4%, up from less than 1% under two years ago.
As a result, the government’s Office for Budget Responsibility (OBR) forecasts the amount of GDP spent paying debt interest is set to average over 3% in the coming years, the most since the 1980s.
“It’s not going to be a one- or two-year job to fix everything. It’s going to be a long slog,” IFS Deputy Director Carl Emmerson said.
This all comes as public services are struggling due to squeezed spending in most areas and lacklustre productivity.
The Institute for Government, an independent think tank, judged last month that schooling was the only area where performance had improved since 2010, and that since 2019 standards had fallen in eight other areas including hospitals and prisons.
An ageing population is the biggest source of spending pressure for the years ahead. But the OBR has flagged other pressures too, including a need for higher defence spending following Russia’s invasion of Ukraine and the cost of moving to a greener economy.
Broken Rule?
Despite all this, Hunt on Wednesday is likely to present a somewhat brighter picture than in March, which he may use to cut some business or personal taxes and inheritance tax, a bugbear for Conservatives.
Asked on Sunday about widespread reports of looming tax cuts,
Hunt told Sky News: “Everything is on the table … The one thing we won’t do is any kind of tax cut that fuels inflation.”
Higher-than-expected inflation has boosted tax revenue and overall GDP in cash terms, giving more leeway against fiscal targets as most public services’ spending budgets are fixed.
The British government’s main fiscal target requires debt as a share of GDP to be forecast to fall between the fourth and fifth year of the OBR’s projections.
While falling debt is a good idea, compared with other countries this target plays a large and “very idiosyncratic” role in British budget debates, according to the Resolution Foundation’s Smith.
As an election looms, the target encourages governments to load up on temporary tax cuts or spending in the first year or two of the forecast, then pencil in unrealistic spending cuts for later on, reducing opponents’ room for manoeuvre.
“I don’t think you have to be tremendously political as a chancellor to refrain from leaving policy space for your successors. However Jeremy Hunt wants to be seen, he will likely do that,” Smith said.
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