Sir Keir Starmer has put Labour MPs on notice that next month’s Budget must fix Britain’s public finances and win over the bond markets, even if it means breaking an election manifesto pledge not to increase income tax.
The prime minister has left open the door to income tax rises, while behind the scenes Labour MPs are being warned higher taxes are needed to build up the fiscal “headroom” against future economic shocks.
“People have grown up in a zero interest rate world,” said one Starmer ally, noting Labour MPs were coming to terms with the fact that Britain was spending more than £100bn a year servicing its debt.
In private briefings, Treasury ministers are talking Labour MPs through the need for Rachel Reeves to build up her £9.9bn buffer against her own fiscal rules. The IMF and other economists have called for the chancellor to increase it, and markets expect it to grow to perhaps £15bn or £20bn.
“The linkage between fiscal policy and bond markets is something that hasn’t been considered in the last 15 years and now needs to be considered,” the Starmer ally said.
“It’s good that people now recognise things have changed. Having the confidence of the bond market isn’t a ‘nice to have’ — it’s essential. It affects how much money we have to spend on public services.”
Reeves, on a visit to Saudi Arabia this week, said she wanted “sufficient headroom” to provide resilience against future shocks.
Rachel Reeves in Riyadh this week with Qatar’s finance minister Ali bin Ahmed Al Kuwari © Kirsty O’Connor/HM Treasury
The chancellor has vowed to bear down further on inflation in the Budget on November 26, in the hopes of smoothing the way to fresh Bank of England interest rate cuts. An increase in income tax would hit demand in the economy and therefore ease inflationary pressures.
Analysts at Goldman Sachs this week predicted the BoE’s Monetary Policy Committee will reduce rates by another quarter-point to 3.75 per cent as soon as next week’s meeting on the back of softening inflation.
“Our confidence has grown that the November 26 Budget will deliver a large, contractionary impulse to the economy,” economists at the investment bank said.
Starmer and Reeves calculate that, if they can bring down borrowing costs, the dividends to the exchequer will come through later in the parliament, opening up the prospect of tax cuts ahead of the next election, which must take place by summer 2029.
One person briefed on Treasury thinking said: “The big question they are asking now is whether to raise income tax to increase the headroom. Markets love tax rises, provided they don’t snuff out growth.”
Starmer on Wednesday declined to confirm that Reeves would stick to Labour’s manifesto promise not to increase rates of income tax, employee national insurance contributions or value added tax, adding to speculation of an income tax rise.
The political dangers of such a blatant manifesto breach are clear, with Conservative leader Kemi Badenoch calling for Reeves to be sacked if she raised income tax.
Taking such a big political risk in the interests of reassuring the bond markets — essential but difficult to explain in the bear pit of Westminster — would be a major gamble for Starmer and Reeves.
Treasury insiders insist no decisions have been taken and much will hang on the final forecasts by the independent Office for Budget Responsibility, which makes its latest private submission to Reeves on Friday.
The hope remains that Reeves can increase her fiscal buffer without having to pull the income tax lever, particularly if the fiscal watchdog is generous in taking into account some more positive recent economic developments.
Among the tailwinds are the prospects of higher inflation and wage forecasts from the OBR, which would swell the nominal size of the economy and the tax base.
Michael Saunders, adviser to the consultancy Oxford Economics, has estimated this could boost tax revenues as much as £9bn in 2029-30, even after a bigger uprating of benefits, while public spending would remain fixed in cash terms.
One revenue-raising option the Treasury is considering would be to partly offset higher income tax with a reduction in employee national insurance contributions, as Reeves seeks to meet her pledge to protect “working people” from the higher cost of living.
In September, the influential Resolution Foundation think-tank suggested a 2p increase in income tax, countered with a 2p cut in the main rate of national insurance. The move would raise about £6bn from people who pay income tax but not employee national insurance, including pensioners, some landlords and the self-employed.
Some Treasury officials are nervous of picking another fight with the powerful pensioner lobby, following the debacle over Reeves’ abandoned plan to remove winter fuel payments from 10mn pensioners.
Pensioners protest against the withdrawal of winter fuel payment in February © Andy Rain/EPA/Shutterstock
A 1p increase to the basic rate of income tax would raise more than £8bn a year in 2028-29, according to HM Revenue & Customs, the tax agency. A 1p increase to the higher rate of tax would lift revenue by £2.1bn, while a 1p boost to the additional, 45p rate, would raise £230mn.
Reeves is also widely expected to extend an existing freeze on personal tax thresholds in the Budget, raising close to £10bn a year. The chancellor was snapped by a photographer on Wednesday with her diary on show, revealing a meeting to discuss “thresholds”.
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Cathal Kennedy, UK economist at RBC Capital Markets, said: “If you can get the markets off your back that will help the strategy and give policy certainty over the next four years and into the next parliament.”
Reeves’ hawkish fiscal signals have helped improve confidence in the UK bond market. Rising hopes of BoE interest rate cuts have pushed down bond yields, after a 3.8 per cent inflation reading for September came in under the central bank’s own forecast.
The yield on the 10-year gilt has slipped almost 0.3 percentage points this month to 4.43 per cent. Yields move inversely to prices.
Reeves hopes some of the savings to the exchequer from this shift will be “scored” by the OBR in its economic forecasts at next month’s Budget.