A view from London

Much has changed in the last year and the chancellor is widely expected to raise taxes by about £20bn this week. The deterioration in the public finances since last year’s budget is due to government U-turns on cuts to winter fuel and disability benefits, higher-than-expected government borrowing costs and downgrades to the Office for Budget Responsibility (OBR) estimate of UK productivity growth.

Fiscal forecasts are prone to large errors and the state of the public finances can shift quickly. At the start of this month the government was generally thought to be facing a fiscal gap of £30bn-£40bn. In response, the chancellor signalled that she was likely to raise rates of income tax in the budget. On 13 November, the Financial Times reported that these plans had been ditched in the light of improved fiscal forecasts from the OBR. Overnight, expectations for the scale of tax rises in the budget dropped from £30bn-£40bn to around £20bn and the government let it be known that it was no longer planning to raise rates of income tax.

I do not recall a UK budget that has been preceded by such extensive speculation about which taxes will be increased, much of it seemingly fuelled by briefings from sources close to the government (often cloaked in phrases such as, “according to people familiar with the matter”).

Of the tax-raising measures available to the chancellor, perhaps the most politically palatable would be to extend the current freeze on income tax thresholds. This would be a deferred tax rise, stealthier than simply raising tax rates, but could be seen as breaching Labour’s manifesto pledge not to raise income tax for “working people”. Extending the freeze in thresholds by another two years, until the end of the current parliament, would raise around £10bn with no immediate effect on taxpayers – but a growing impact from 2030. Other tax-raising measures that have won significant media coverage include raising council tax on top-band properties and reducing the tax benefits of salary sacrifice pension contributions.

Avoiding broad based increases in personal tax, such as VAT, national insurance and income tax, may be politically attractive. But shifting the burden of tax increases to a series of smaller tax changes is not without risk. They can create large losses for small groups of taxpayers, adding complexity and inefficiencies to the tax system and attracting high-profile opposition. Time and again chancellors have had to reverse course on proposed tax rises due to opposition, perhaps most famously in 2012 when George Osborne had to backtrack on a plan to charge 20% VAT on hot takeaway food, including pasties. The same problem applies to planned reductions in welfare spending, as demonstrated by Ms Reeves having to back down on proposed cuts in winter fuel payments for pensioners and disability benefits in response to opposition from her own party. Whatever measures the chancellor announces this Wednesday will need to win the support, or at least acquiescence, of her own party and of parliament.

Tax rises will be necessary for Ms Reeves to meet one of her stated aims for this budget, to reduce public debt. The greater question is whether she can convince markets that the UK public finances are on the mend. We expect the chancellor will pencil in a margin of error to meet her debt target of about £15bn. This is minimal by the standards of budgets in the last 15 years. With public spending running at around £1,335bn a year it wouldn’t take much to go wrong for a reserve of £15bn to be swallowed up by events.

Without a larger fiscal reserve, or an improvement in growth prospects, markets will remain sensitive to the risk of further slippage in the UK public finances and more tax rises. That, in turn, could weigh on business sentiment, just as it has in recent months (as the headline for the latest Chambers of Commerce business survey put it, “Bruised firms not ready for another budget battering”).

This year’s budget seems likely to lay out a fiscal consolidation programme relying almost entirely on tax rises. With the tax burden already at the highest level since the 1940s, further tax rises will weigh on growth and, more worryingly, risk blunting incentives. Moreover, relying solely on tax rises to right the public finances looks risky. Numerous academic studies show that successful fiscal consolidations place more weight on reductions in public expenditure than on raising taxes. A 2018 study by Harvard economist Alberto Alesina and his co-authors, looking at 16 OECD countries over a 30-year period, found that tax rises tend to have a greater dampening effect on growth than spending cuts.

Alongside debt reduction, the chancellor says she wants to reduce NHS waiting lists and reduce the cost of living. The government has already announced that it will leave prescription charges unchanged next year and has also announced the first freeze in rail fares in 30 years. The chancellor is widely expected to reduce VAT on energy bills and lift the two-child benefit cap in the budget.

In terms of her objective of bringing down inflation the chancellor has chosen an easy target. Inflation has already peaked and, with or without any new measures from the government, is likely to fall substantially by the middle of next year. Any ‘cost of living’ measures announced by the chancellor would help this process along.

This week’s budget will no more solve the UK’s fiscal problems than last year’s budget. Righting Britain’s finances will take years. Levels of public debt have roughly tripled since the turn of the century. The burden of tax is higher than it has been in more than 70 years. Public spending is running way above post-war averages. The state is spending, taxing and borrowing on a grand scale, yet public satisfaction with key services, such as health and social care, is low. Most fundamentally, growth today is running around half the rate that was seen before the financial crisis.

This budget, like last year’s, seems likely to lean heavily on tax rises. Big questions on the size and role of the state will have to wait.