Reeves has herself set two metrics against which her budget should be assessed: a)
that current expenditure should be matched by tax income (in any one year), and b)
that there must be fiscal room, via borrowing, to fund public investment expenditure.
These are her fiscal rules in outline.
Generally, this is a sensible and prudent approach, save for one caveat. The balance
of taxation and current spending should be over a cycle and need not be met in each
year.
As far as the current expenditure impact of her first budget is concerned, taxation as
a proportion of GDP will rise to 38% in year 2029/30, with tax (and spend) both rising
at £36 billion per annum for five years (OBR 2024).
Nonetheless, despite the tight tax and spend rule, the budget is regarded as
representing a fiscal easing, because of the borrowing to fund capital investment.
Using Reeves metric of public sector net financial liabilities, PSBNL (see below) will
“free up” to £32 billion (around 1% of GDP) per annum over five years, for public
borrowing to be invested in public capital projects. (OBR 2024).
The implication of this judgement – and the assumed fiscal easing (OBR calculation,
see below) – implies that the reduction oof interest rates by the BoE is likely to be
slower in 2025 than previously forecast.
The financial markets’ response has been nervous, but not overly so. Bond rates
have gone up, though this is significantly affected by the US financial markets
situation, including the advent of a second Trump presidential term. Obviously, this
will have negative impacts, especially on mortgage markets. However, bond rates
are likely to ease, at least as far as the UK budget impact is concerned, over the next
few months.
This paper will not delve deeply into the arcane nature of the various tax changes
introduced, save for some discussion of the employer National Insurance (NI)
imposts, but will present a GPI overview of the intent and structure of the budget.
Instead, a broad political and macro-economic response to its overall impacts. There
is a plethora of other commentaries on the detail of the budget that can be consulted
(such as IFS 2024).
Tax and Spend
Tax
As noted above, the Treasury estimate of the total tax take and public spending
during next five years is £36.2 billion (around 1% of GDP) per annum for 5 years,
with a matching public current expenditure.
Around 75% of the total tax increase in the budget is that imposed on
businesses in the form of the 8% increase (from 13.8% to 15%) in the
employer National Insurance contributions However, the small business
exemption threshold level, at which they become liable for NI tax, has
decreased from £9100 to £5000, so affording some protection for small firms.
Also, the employment allowance claimed by employers paying less than
£100,000 in any one year will be increased from £5000 to £10,500, thus
alleviating the impact on medium-sized companies. In some industries where
self-employment is common, such as construction, the NI hike may increase
the rate of self-employment.
Much of the negative business reaction to the budget has, not surprisingly, come
from businesses, especially the retail sector. The 20% tax on inherited farmland has
also raised concern among some farmers, despite government assurances that a
relatively few farms will be affected (see also IFS 2024).
It should be noted that as with any direct tax on businesses, the impacts will be
spread across the employer (profits), the employee (wages, and potentially
employment), and the customer (price increases). The exact proportions across
these three impact directions will vary given the nature of the business and the
markets operated in.
Despite the fact that there have been no specific increases in income or sales taxes,
the retention (though not further extension) of the non-uprating of personal income
allowances means that more people, including some state pensioners will be paying
income tax in the next financial year.
Spend
Current expenditure on public services over the five-year forecast period will grow by
around 1.4% per annum meaning that, ignoring inflation, there will be a need for
significant improvements in productivity within every public service. The NHS has
been given a substantial, around 2.5% increase in spend, in order to kick-start
reform and productivity increase. On the other hand, it is difficult to see how the
prison service and probation service are going to be capable of improving
performance with a 1.4% increase in current spend.
According to the OBR the size of the state sector at the end of the five years will be
44%, compared to the pre-pandemic level of 39%. In fact, this was the same figure in
2022. However, according to the IMF (IMF 2023) the level of government
expenditure, as a percentage of GDP in 2022, was 58% in France, 49% in Germany,
53% in Finland, 47% in Sweden, and 38% even in the US. It is not clear what point is being made by the OBR, by simply observing the UK historical situation outside an
international context.
Moreover, demographic and accompanying public health impacts imply the need for
significant public expenditure increases on health and social care, and more
generally on wider public services to make up for shortfalls in various areas, such as
the criminal justice system.
There are only two ways of avoiding the increase in public expenditure on public
services, especially health and social care, in a modern economy, namely, to use
public and private insurance. The US provides an example of the failure of the
private model, though it will be argued that the social insurance model in Germany
works well.
The UK has chosen historically to fund its heath service, especially its acute hospital
medicine, via general taxation, including national insurance contributions, though this
tax funding has for many years covered only a proportion of NHS costs.
Social care in the UK is at the present time substantially funded privately. There was
no mention of reform of social care in the budget. It is not clear how far the
significant increase in NHS spending will be able to be devoted to provide public
social care in conjunction with local authorities.
Net Borrowing and Investment
Net Borrowing
Reeves has chosen to move to a definition of the public sector borrowing
requirement that is expanded to take account of net financial liabilities, PSBNL. In
the case of the metric chosen by Reeves it means that, for instance, the net long-
term financial liabilities of say student debt can be estimated and considered. It looks
as if use of this metric will “free up” to £32 billion (around 1%) per annum over 5
years, to be invested in public capital projects. The pattern of this investment
expenditure over the next five years is uncertain.
N.B. Others, including IPPR (2024), have recommended PSBNW as a metric. This
measure takes account of public sector net worth (a metric used by the New Zealand
government), including the value of public net assets as well as liabilities. The
problem with this latter measure is that it requires the valuation of public sector
assets such as schools and hospitals, about which there is no consensus on such
valuations. The suggested approach is simply to apply the Treasury discount rate for
capital spend on 3.5% for all public assets expenditure. Hence, though PSBNW
would be likely provide a larger potential level of public funds for borrowing to invest
than PSBNL, it is not without problems in its adoption and use.
The extra estimated net borrowing available via PSBNL accounting represents a
fiscal easing of around 1% of GDP per year, according to the OBR. However, insofar
as this expenditure increases economic growth (including leveraging private investment) then it will be self-financing. One problem is that markets, and the OBR, appear to regard public investment per se as not leading directly to growth. Because it may “crowd out” private investment as the economy nears full capacity (based on the somewhat spurious calculation of the “output gap” by the OBR in their commentary. The model calculations involved are very unreliable, as indicated in the main text above.
Investment
The aim is to ensure not only successful public investment per se in terms of improvements in the productivity of public services, but also to leverage productive private investment. The OBR agrees that this latter key benefit for economic growth will occur in the first two to three years of the five-year forecast period but will fall in the last two years due the “crowding out” of private investment. (see comments in the OBR Commentary section below below).
What will be important is that as well as the direct economic benefits of the public investment to measure how effective is the selection of public investment are in terms of leveraging private investment. There is, of course, also the problem of how to define public sector capital spend. In the NHS, the de-minimis level is sums above £5000 on projects that can be classified as capital expenditure on capital that will last more than a year. In local authorities it varies, depending on the size of the council.
For district councils the de minimis level is £5000 to £10,000. For schools, outside
local government the de minimis level is set at £2000.
It should be recognized that many public investments, therefore, may not be major
infrastructure investments, but smaller productive capital projects within the above
public sector capital spends.
One good example of a large public infrastructure investment leveraging private investment will be the apparent plan to improve the poor rail connections between Manchester, Leeds, and York, which should then lead to increased private business and other investment along this route.
As regards private investment, this too has lagged behind comparable nations and both its quantity and quality needs to improve. The broad aim of the budget and the more specific aims of the government’s industrial strategy (Gov. UK 2024) are to work in concert with the private sector to enhance investment and economic growth.
Achieving this aim is likely to require improvements in the cost-effectiveness of the
private sector as well as the public sector. The engineering sector and other manufacturing has seen considerable technological advancement, and the services sector is now seeing similar advance in some (such as gaming and healthcare), but not all, sub-sectors.
The UK construction sector tends to blame the faulty and over-regulated planning
system and other regulatory hurdles for its failures. However, the structure of the
sector, with substantial outsourcing of equipment and labour, and long supply chains, is also a problem. Comprehensive and efficient project management is the key to improved management of the sector.
Official Commentary on the Budget: The OBR
The new government appears to be committed to increasing the powers of the OBR that may lead to a transfer of policy influence from the elected Chancellor to the technocracy. Even without new legislation the commentary of the OCR on the current budget is likely to be influential, especially on markets. For instance, the OBR suggests that in the second half of its five-year forecast period the increase in public borrowing for investment is likely to “crowd out” private investment and lower economic growth.
This scenario is predicated on the macro-modelling estimate that the output gap will
shrink and thus limit the ability of the economy to grow. The estimate of the output
gap is regarded by many economists, including the OBR itself in an earlier paper
(OBR 2014) to be subject to significant revision, whichever method is used to
estimate the gap. Others have, over a range of years suggested that the estimates
are too unreliable to be used on their own in forecasting by central banks (Quast and
Walters 2023; ECB 2007). Unfortunately, output gaps and equally untenable
unobserved variables such as neutral rates of interests (r*) are still used extensively by central banks in their modelling.
These critical comments should not be interpreted as suggesting that economic modelling should not be used as a guide to policy-making. However, such exercises (with appropriate caveats about the estimates involved, should be regarded by politicians and commentators with scepticism. The desirability of handing over democratic political judgements to economic technocrats is a danger that GPI has previously raised.
Conclusion
In common with much of the analytical comments on the budget, we can give a generally positive overall response to the budget, save for some of the complaints from small businesses in terms of the lowering of the threshold for exemption from the employers raised NI.
Large employers should be able to cope with what is a relatively small increase of around 8%. Generally, any tax impost of businesses has three impacts: on profits, on wages and employment, and on customer prices. The split between these will depend on market conditions and the ability of the company to absorb the increase.
It is perhaps important also to recognise that ultimately all taxes impinge on individuals, whether they be landowners, company-owners, workers, or consumers. All these groups are linked to the state by a notional social contract, whose aim is to provide economic well-being for citizens, including the provision of cost-effective public services.
The rather negative comments of the OBR on economic growth in their five-year forecast should not be regarded as sacrosanct, as should many other five-year forecasts based as they are on inadequate macro-economic modelling. At best, the OBR modelling may provide guidance as to potential scenarios. Moreover, subsequent budgets may enable adjustments to be made to growth forecasts, especially focussing on how the government’s industrial strategy progresses, aided by further annual budgets.
Hence, this first Labour budget should be judged on its short, one-year impacts. There will be spending reviews and further budgets to come, that will provide a clearer picture of whether the pro-growth economic strategy of the government can be facilitated by both government policy and investment and by accompanying private investment.
The rhetorical political commitment of the government to this long-term supply-side approach to lifting both UK technological productivity and economic growth to levels able to increase overall prosperity and to fund the public services required (given the demographic challenges faced by the UK) is clear. It is a gamble that needs to see some fruits of the approach by the time of the next general election in 2029.
However, no government can force or even encourage private companies to invest if they are unwilling, without further reform of the financial sector, both capital markets and banks. Moreover, the corporate board structure of large UK companies is not one that provides confidence that productive as opposed to financial investments are likely to be forthcoming. This is also true of UK banks.
Another key issue is the stagnation of real wages and per capita income. In the US, the top 20% of households by income spend more than the bottom 60% (ING 2024). A key to achieving a consistently higher level and rate of private investment is making sure that the 60% majority of working households receive higher wages to ensure higher overall demand for mainstream products and, increasingly, services. If the UK figures are similar to the US, and do not change, then the UK average household is not going to feel better off in five years’ time. The idiosyncratic expenditures of the top 20% will be insufficient to drive the whole economy forward.
These are all areas of concern on which it is not clear that the Labour government
has any plans to intervene or reform. Without significant private financial sector as
well as public sector reform, and reform of the distribution of income, the successes
on Labour’s long-term supply-side approach may not be manifested by the time of
the next general election.
References
ECB (2007) ‘Potential output estimates for the Euro Area’, www.ecb.europa.eu/pub/pdf/other/mb200907_focus04.en.pdf
Gov. UK (2024) ‘Invest 2035: UK's modern industrial strategy’, https://www.gov.uk/government/consultations/invest-2035-the-uks-modern-
industrial-strategy/invest-2035-the-uks-modern-industrial-strategy
IFS (2024) ‘Autumn Budget 2024’, https://ifs.org.uk/collections/autumn-budget-2024
IMF (2023) ‘Government expediture.as % of GDP, international comparisons’,
https://www.imf.org/external/datamapper/exp@FPP/USA/FRA/JPN/GBR/SWE/ESP/ITA/ZAF/IND
ING (2024) ‘Getting some answers from the US consumer puzzle’, https://think.ing.com/articles/getting-some-answers-from-the-us-consumer-puzzle/
IPPR (2024) ‘Budgeting better’, https://www.ippr.org/articles/budgeting-better
OBR (2024) ‘Output Gap measurement: Judgement and uncertainty’, Working Paper No 5, https://obr.uk/docs/dlm_uploads/WorkingPaperNo5.pdf
https://ifs.org.uk/budget-analysis
OBR (2014) ‘Output gap measurement, judgement and uncertainty’, Working Paper No 5, https://obr.uk/docs/dlm_uploads/WorkingPaperNo5.pdf
Quast, J. and Walters, M. H. ‘The Federal Reserve's output gap: The unreliability of real-time reliability tests’, Journal of Applied Economics,Vol. 38 Issue 7: 1101-111,
https://onlinelibrary.wiley.com/doi/full/10.1002/jae.3003tps://www.ecb.europa.eu/pub/pdf/other/mb200502_focus05.en.pd