Reeves can raise taxes as much as she likes, but it won't bring in any more money

Telegraph

4 days ago

The IMF has warned Chancellor Rachel Reeves that she must make tough choices to cut the UK's deficit, potentially including some combination of raising taxes on working people, abandoning the pensions triple lock or charging for the NHS. The first of these options – raising taxes – is considered politically the most likely. After all, Labour MPs didn't even agree to cuts to winter fuel payments. It's impossible to imagine them agreeing to cut the NHS, and abandoning the triple lock seems like political suicide.
Yet it's highly doubtful whether raising tax rates further will produce any more tax revenue out of the UK economy. Even as matters stand, taxes are scheduled to go higher than they've ever been since World War II, and to be around 37½ percent of GDP for the rest of this Parliament. But that considerably understates the situation. Prior to 2021/22 they'd only ever once been above 35 percent of GDP since the 1950s, in 1969/70, and then for only one year before falling back sharply. Thereafter, until the 2020s, it was rare for them to be above 33½ per cent of GDP. We aren't merely at a record. We are at an out-of-the-park record scheduled to be sustained for an absolutely unprecedented period of time. The chances of the UK economy delivering even the tax levels already scheduled are slim, let alone imagining taxes could be raised a lot further.
Yet despite these astonishing record-high taxes, the economy is still running a large deficit of over 5 per cent of GDP. Remember the 'Maastricht Convergence Criteria' requiring budget deficits to be no higher than 3 per cent of GDP? Well, we're way above that. When the deficit exceeded 6 per cent of GDP in the 1990s we had a significant fiscal consolidation under Norman Lamont and Kenneth Clarke. Yet at that time the UK's national debt was under 40 per cent of GDP. Now it's over 100 per cent. Our situation is way worse than it was in the early 1990s.
We need a fiscal consolidation to address that 5 per cent deficit. But the current thinking appears to be that all of that deficit cut will come from tax rises. Indeed, possibly more than all of it, because spending will probably go up further. To balance the books we'd need to rise from that record 37½ per cent of GDP spending to over 42½ per cent. Add in a percentage point for further spending rises and we'd be over 43½ per cent or fully 10 percentage points of tax higher than the UK has ever produced on a sustained basis in well over 80 years.
One key reason tax takes top out at some point relative to GDP is that they destroy growth. Over the long-term having a high share of tax in GDP damages long-term growth – each 10 per cent rise in tax reduces the growth rate by around 1.2 per cent – which in the UK's case would mean reducing its sustainable growth rate to zero. In the short-term, raising taxes often triggers recessions, bringing down tax revenues.
That loss of tax revenues as growth peters out, or outright recession ensues, means that tax-based fiscal consolidations typically don't work. If you have a high deficit, raising taxes is almost never a way to cut that deficit – even if it were a Good Thing to have higher tax in itself, it simply doesn't work in that situation. The normal advice the IMF and similar bodies used to provide in fiscal consolidations was that they should be predominantly spending cuts-based. The IMF often used a rule of thumb of about two thirds spending cuts to one third tax rises. The EU used much the same rule of thumb in the Eurozone crisis era austerity programmes.
However, the most successful consolidations – the ones where the deficit falls and stays down, with debt dropping away relative to GDP over time – tend to have higher ratios of spending cuts, of around 75 to 80 per cent to 20 to 25 per cent tax rises. We need at least that ratio in the UK now, if not higher. But that is not what Labour backbench MPs will ever agree to.