Are tax rises inevitable?

If you believe the smoke signals from the Treasury – and you probably should – the Budget on 17 November will have to include big increases in tax in order to plug a ‘black hole’ in the public finances. But is it inevitable that taxes will have to rise and, if so, what’s the best way to do it?

The obvious starting point is the ‘black hole’ itself. Different numbers are regularly tossed about here, with recent estimates ranging from around £30 billion to more than £70 billion. However, few people understand what these mean. The size of the ‘black hole’ depends on two main factors.

The first is the set of fiscal rules against which the public finances are assessed. The ‘black hole’ is the difference between the forecast path for public sector borrowing on current policies and where borrowing needs to be to hit the government’s targets. The Treasury also likes to build in some ‘headroom’ to increase the confidence that the targets will be met.

The second is the set of assumptions that feed into the Office for Budget Responsibility’s forecasts for borrowing and debt, notably on economic growth and inflation. But also on market variables such as expectations for interest rates and commodity prices.

The upshot is that there are an awful lot of moving parts here, and estimates of the size of the ‘black hole’ should be regarded with far more scepticism than is usually seen.

For example, the £50 billion figure currently doing the rounds seems to assume a ‘black hole’ of £40 billion and another £10 billion of ‘headroom’, just in case. So that’s £10 billion that could be knocked off straightaway (either on the basis that the risks to the OBR’s forecasts should be symmetric, or that if the economy does do worse than expected it would make little sense to tighten fiscal policy even further).

What’s more, these numbers are typically based on a fiscal rule that the ratio of public sector net debt to national income should be falling ‘over the medium-term’. This could mean almost anything. The consensus is that the Treasury will settle on a five-year horizon, meaning difficult decisions are being taken now on the basis of highly uncertain forecasts for the evolution of borrowing and debt between now and 2026-27.

Indeed, the inputs to these forecasts are changing all the time. For example, market expectations for interest rates and commodity prices, especially natural gas, have fallen sharply in the last few weeks. This is why just a brief delay to the timing of the fiscal statement might have reduced the ‘black hole’ by as much as £15 billion.

In my view, this is no way to run fiscal policy. Raising taxes and cutting spending, even as the global economy slides into recession, might increase credibility with the financial markets, and the painful experience of the past few months has shown why this is important.

Nonetheless, the fetishising of a single set of OBR forecasts is dangerous and could lead to serious policy mistakes, with substantial economic and social costs. The old ‘doom loop’ of renewed austerity, poor growth, and deteriorating public finances is back on.

But we are where we are. The assessment of the ‘black hole’, and the policy responses to it, are unlikely to face serious challenge or scrutiny, and certainly not from the Treasury’s handpicked ‘Economic Advisory Council’. (OK, perhaps I’m indulging in some sour grapes on that last point!)

So, on the assumption that there is a need to find up to £50 billion of savings by 2026-27, what’s the best way to do it? The Treasury has suggested that savings will be split 50-50 between tax increases and spending cuts. On the tax side at least, some of the ideas being floated are not completely mad.

The challenge, of course, is to raise more money without undermining household and business spending even further, or doing too much damage to the supply side of the economy. In these respects, extending the freeze on personal allowances and expanding the windfall tax on energy companies are perhaps the least bad of the various options.

On personal allowances, it is worth stressing that income tax and National Insurance thresholds are already frozen until 2025-26. Extending that for, say, another two years would not mean that people pay more tax now, when the economy is most fragile (though the prospect of higher taxes in future, even ‘stealth taxes’, may still damage confidence in the meantime).

A freeze on personal allowances could also be less damaging to incentives on the supply side. Compared to the alternative of raising the headline rates of income tax or National Insurance, which would affect the marginal rates paid by over 30m people, a freeze on allowances might ‘only’ drag another 2-3m into paying higher rates of tax.

Similarly, an expansion of the windfall tax on energy companies should do less harm to consumer spending than further increases in personal taxes, and send a less damaging signal to businesses than a further increase in corporation taxes across the board.

Nonetheless, it would not be cost-free either. Haphazard increases in windfall taxes, which are essentially arbitrary, will add to the general climate of business uncertainty and deter investment in a crucial sector of the economy.

In short, are tax rises inevitable? Not necessarily. They are still a policy choice, based on an assessment of the economic and fiscal outlook, the risks around it, and the rules that the government decides to set for itself. The Treasury could also lean more towards spending cuts. But realistically, the ‘tax and spenders’ are back in charge. All we can hope for now is that taxes are raised in the least damaging way.

This article was first published by CapX on 2nd November 2022

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