So far, the speculation ahead of the Budget on 30 October has focused on the scramble to find tax increases that might not breach Labour’s manifesto commitments, while still having some chance of actually raising some money.

This is clearly not going well. Rachel Reeves may end up as the only economist in the country who is willing to argue that employer’s National Insurance is not a tax on ‘working people’. And her past statements in Parliament suggest that even she accepts that it is.

But a row is now brewing on the spending side too. It has been reported that several Cabinet ministers have written directly to Keir Starmer expressing alarm about the scale of additional spending cuts that their departments face in the Budget.

This group is apparently led by the Prime Minister’s own Deputy, Angela Rayner, who is also responsible for housing, communities and local government. Others include the ministers in charge of transport and justice.

The optics here are terrible. Labour politicians have vowed that there will be no return to what they call ‘Tory austerity’. Despite this, some of the departments which have seen the biggest real-terms cuts in day-to-day spending since 2010 are now being asked for even more.

How did we get here? The Chancellor has promised to reinstate the ‘Golden Rule’ that the ‘current budget’ must be brought back into balance so that day-to-day spending is covered by tax revenues. As a result, the government should borrow only to invest.

This makes good economic sense. Current spending mainly benefits current taxpayers, so it is fair that they should pick up the bill. But it is reasonable to borrow for investment in capital projects that will mainly benefit future generations. The scope for borrowing to invest will still be limited by the other main fiscal rule, which is that debt has to be falling as a share of national income by the fifth year of the OBR’s forecast.

However, the spending assumptions inherited from the Conservatives already imply a tight squeeze on day-to-day spending in key areas. The latest speculation is that creating more space here – while still meeting the ‘Golden Rule’ – could require between £35 billion and £50 billion of savings from a mix of tax increases and spending cuts elsewhere.

The new fiscal rules do not allow any shortfall on the current budget to be filled by additional borrowing. Admittedly, there may still be some wriggle room here, depending on the time horizon over which the ‘Golden Rule’ is applied.

If the requirement is simply to balance the current budget by the fifth year of the forecast horizon, it might be possible to borrow a little more for day-to-day spending now. But this would only delay the pain. Moreover, the Chancellor is already likely to tweak the definition of debt used in the debt rule to allow a lot more borrowing for investment.

Even now, this is starting to unsettle the financial markets. Investors are increasingly nervous both about the large amount of additional government bonds they will have to buy, and about the impact of a splurge in spending on inflation and official interest rates.

The markets might be more relaxed about new investment that boosts the productive potential of the economy, so that faster growth creates more tax revenues to service the additional debt. But it is not clear that this applies to many of Labour’s early proposals, notably the ‘green energy’ projects being pushed by Ed Miliband. In any event, the markets will be less sympathetic to increased borrowing purely for day-to-day spending.

So, what to make of all this?

Let us assume the Chancellor has a shortfall of £40 billion. The political optics alone suggest that she will want to find most of this sum from tax increases, in order to minimise the flak from critics saying this is a return to ‘austerity’.

A package of measures based around increases in Capital Gains Tax (especially on shares) and in employer’s NI (notably extending them to pension contributions) might scrape together about £25 billion. But that is a stretch. And the more that can be found in spending cuts, the less that taxes have to rise.

The question then is where will the axe fall this time?

At one extreme, there are plenty of things that the Chancellor could do that would be unpopular but probably quite sensible. The decision to restrict Winter Fuel Payments to those on Pension Credit might set a precedent for a wide range of similar savings. For example, there is a decent case for raising the age at which people qualify automatically for free prescriptions on the NHS (the current threshold of 60 does seem low).

At the other extreme, there is risk that the axe falls again on services that are already under-funded and, just as importantly, cannot be left to the markets (those that economists call ‘public goods’). The criminal justice system is a prime example. We need more spending on courts, prisons and legal aid, not less.

But in the middle, there is a huge amount of government spending in areas where the state should not be involved at all. Or at least where it is involved, it could be much more efficient. Instead of raising taxes even further, or cutting vital services, there should be a relentless focus on fixing the productivity crisis in the public sector, and on making savings on the welfare bill.

The previous government was at least starting to make progress on these fronts. Unfortunately, it looks like the new Chancellor has already boxed herself in to a toxic combination of damaging tax increases and false economies on the spending side.   

This piece was first published in the Daily Telegraph on 18 October 2024

• Applied economics
• Everyday Economics
• financial markets
• Fiscal Policy
• Politics
• productivity
• Taxation
• UK economy