Sir Keir Starmer and Rachel Reeves have junked plans for income tax rises – Temilade Adelaja/PA
When Rachel Reeves stood up to deliver an unusual speech ahead of the autumn Budget earlier this month, her message was clear: everyone should brace for financial pain.
It was widely interpreted as readying the ground for a manifesto breach and the first rise in the headline rate of income tax in 50 years. “If we are to build the future of Britain together, we will all have to contribute to that effort,” the Chancellor said.
Yet no sooner had the public digested the message than the plan changed. The Chancellor has junked plans for income tax rises, instead opting to target a range of smaller revenue raises.
What prompted the volte-face?
This week the Office for Budget Responsibility (OBR) handed the Chancellor a gift in the form of a smaller-than-feared estimate of the hole in public finances. The tax and spending watchdog is thought to have said it reckons there is a £20bn gap – £10bn less than had been feared.
In an unusual move, the OBR also moved the 10-day forecast window used to calculate borrowing costs, shifting it from a time when they were high to a more favourable period. The delay gives the Chancellor a £1.7bn lifeline, which has helped reduce the repair job she faces.
Two key judgments have probably helped Reeves, James Smith at Resolution Foundation believes.
The first is on pay. He points out that workers have seen bigger pay rises than the OBR had expected, bringing in bigger revenues for the Treasury as they pay more income tax.
Economists had initially believed that companies would look to squeeze wages to bolster their profit margins. “That picture actually looks a bit different now,” Smith says.
The OBR’s assessment includes a judgment on how fast it thinks wages will continue to grow. Depending on just how radical the watchdog has been, it could benefit Reeves by as much as £20bn. A more middle-of-the-road assumption would be a £13bn boost, which is Smith’s prediction.
The second judgment is on productivity. It has been well trailed that the OBR is downgrading its verdict of how fast the economy can improve its productivity, cutting it by 0.3 percentage points. Many economists had expected this would cost the Chancellor £20bn or more.
Reeves even highlighted the big impact in her speech on Nov 4, warning that “a less productive economy … has consequences for the public finances, in lower tax receipts”.
However, the actual hit has probably been less severe, Smith thinks. Weak productivity gains were already largely factored in for three of the five years covered by the forecasts, meaning the blow is more likely about £14bn.
Briefings from No 11 suggested it was these rosier forecasts from the OBR that prompted the about-turn on tax. Yet economists and political strategists are sceptical.
The Government would have known for some time that it had a dose of luck, says Ben Zaranko, at the Institute for Fiscal Studies. The OBR produces five rounds of forecasts in the run-up to the Budget, setting out what state the public finances are in and what impact the Government’s plans might have.
“The underlying forecast should not have changed much at all,” Zaranko says. “The pre-[Budget] measures economy forecast was already presented to the Chancellor a couple of weeks ago.
“What it could be, maybe, is that some of the forecasting judgments interact with the policies that have been proposed. But they won’t have taken a drastically different view of where the economy is going compared to a few weeks ago.”
Zaranko believes there could be another explanation for the change of heart in Downing Street. He speculated in a post on X: “Here’s an extraordinarily cynical take: did the Government talk up the likelihood of a manifesto-breaking income tax rise in the knowledge that it would push down gilt yields in the window the OBR will use for its forecasts?”
In essence, he is suggesting that Reeves could have sought to swing borrowing costs in her favour by proposing a policy she was never going to adopt in an effort to please investors.
If that was the case, it has been incredibly bad politics. No one is celebrating the canned income tax rise – neither backbenchers nor bond traders.
“It’s utterly incomprehensible, because it’s not strategic,” says John McTernan, who was Sir Tony Blair’s director of political operations. “You’ve rolled a pitch for a test match, and now you’re off to play snooker. It’s utterly confusing. I don’t think anybody’s happy.”
The decision to scrap the rise in income tax rates was greeted by traders like a maggot in a £100 meal. The FTSE 100 fell by as much as 2pc, the pound hit a new two-year low against the euro and gilts sold off, erasing most of their steady decline over the past month.
McTernan describes the mood among Labour MPs as “a mixture of sad, angry, bemused and confused”.
It comes after a remarkable week where Sir Keir Starmer appeared to fend off a leadership challenge after anger over the looming manifesto breach. That too may be another explanation for the about-turn.
McTernan believes the flip-flopping is not about the OBR, but the threat facing Sir Keir Starmer.
“It is simply a response to the ongoing leadership challenge. The first shot in the inevitable leadership challenge for Keir Starmer was this week, when No 10 tried to destroy Wes Streeting and failed. They’ve left him stronger.
“They’re accepting that the Budget would have caused such a revolt among Labour MPs who would have found it hard to make the argument [for a manifesto breach] that they’ve decided to drop it.”
McTernan adds: “It is hard to understand it as a communication or fiscal strategy. It’s very easy to understand it as a political strategy of positioning against a potential and, I think, inevitable leadership challenge.”
Meanwhile, warnings of big tax rises have already done economic damage, Smith warns, pointing to briefings from the Bank of England’s agents speaking to businesses up and down the country.
“Both the agents and some of the survey data seem to suggest that Budget uncertainty was weighing a bit on sentiment coming into the fourth quarter of the year,” Smith says.
When Reeves was first handed better-than-expected forecasts from the OBR, it would have looked like a gift. Somehow the Chancellor and Prime Minister have contrived to turn it into a disaster.
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