Rachel Reeves has, it’s been reported, binned plans to raise income tax in the Budget on 26 November.
In recent weeks – specifically in that surprise speech – she had strongly indicated that a manifesto-breaking rise in income tax was both necessary and likely.
Reports in various publications today claim she has now abandoned that idea, which has seen gilt yields jump again. Volatility like this ahead of the Budget is very unusual, as is the constant briefing and kite flying of ideas.
We’ve been noting here the risks involved in raising income tax – specifically that while it would tend to calm markets, it would inflame voters and MPs, leading to political instability as both Reeves and PM Starmer would be fighting for their jobs, and likely lose.
So it looks as though the pressure has told – now a new set of calculations need to be considered, ones which rely on squeezing lots of different parts of the fiscal balloon at the same time. As the IFS points out, using other means to raise tax will feed back more directly into lower growth and productivity, further hampering the efforts to reduce debt.
It’s worth going over some scenarios we’ve been outlining as possible at the Budget. (remember that the Budget is now an ‘iterative’ process whereby the Chancellor sends ideas across to the OBR for consideration, they mark it and then she reworks it. This means we don’t actually know what will be in it until 26 November).
- Tax hikes + no major spending increase = more headroom, contractionary but not inflationary = gilt markets happy, BoE cuts more to stimulate growth…this means yields fall, sterling is steady.. Risk is rebellion leading to political uncertainty, which spikes bond yields on threat of left-leaning takeover.
- Go bigger on tax hikes, enables BoE to cut even more…growth weaker but market happy that yields falling faster. Risk as above but more elevated. Sterling is hit.
- Go small on tax hikes – pushes up yields and risks credibility (need to come back for more), headroom too small…fiscal risk premium for gilts shows up in sharply weaker sterling.
- Do wrong tax hikes, increase spending too much (eg Living Wage, two-child benefit cap) – too inflationary, BoE scope for cuts reduced.
The first two of these are probably the most ‘market friendly’ on the face of things…but miss out the key unknown quantity within the equation: MPs. If Reeves carries off what the markets like best then it likely means a significant tightening, slower growth and a manifesto-busting hike to income tax. This then feeds into unrest among MPs who are already fit for rebellion.
The assumption was that somewhere between 1 and 2 was the most likely – an income tax hike signal certainly pointed in this direction.
Now, it seems, she’s decided to go back to the drawing board and scratch around for loose change down the back of the sofa.
So we are left with scenarios 3 + 4, or a combination of the two. The risk is tax hikes that lower growth, hitting productivity, whilst also pushing up inflation, which curtails the ability of the Bank of England to open the release valve of lower interest rates.
There will be more back and forth between the Chancellor and the OBR, most test balloons flown and more political capital spent.
The Chancellor is between Scylla and Charybdis – please markets or please the people. Please the markets and the party and people revolt, please the party and markets go vigilante. Both routes end in the same place.
