Avoiding austerity 2.0: Why is the government considering tax rises at the budget?

When it takes years before cases come to trial, 12 months or more to see a medical specialist, or 15 hours to be seen at A&E – it’s no exaggeration to say some of our public services are in a state of failure.

Not only does this have consequences for our lives – the wasted nights at the local hospital, the years waiting for justice, the months spent on remand – but it has economic consequences too. As the International Monetary Fund noted in its July 2024 assessment of the UK economy, and as IPPR’s Commission on Health and Prosperity discussed in depth, pressures on public services are a constraint on economic growth.

Worse still, a service in crisis becomes an accelerator of problems elsewhere. Shortages of staff in care homes leads to people spending longer in hospital leads to backlogs in A&E. Lack of funding for special educational needs provision leads to inadequate support in schools leads to teachers spending more time each day making up for inadequate community services.

While fixing the situation is a priority for the new government, there are no easy solutions. In the medium term, investment in better technology and data systems can improve productivity. The announcement this week by Wes Streeting of ‘patient passports’ is one example of seeking to do this. IPPR modelling shows that if the NHS put much more effort into prevention, it could reduce spend by as much as 1 per cent of national income in five years. But introducing such changes takes time and the crisis is happening now.

This speaks to an eternal challenge when trying to improve failing services. It is very difficult to reform when you’re on your knees. With every moment of staff time spent juggling exactly how to fill each bed from the queues in the waiting room, it’s hard to have the capacity to step back and make long-term improvements.

What this means in the immediate term is that additional funding is needed to get services out of crisis mode and to unlock public sector productivity. This raises the question of where the money is going to come from, given the government’s commitment to funding current expenditure from revenue rather than borrowing. In addition to the £20 billion ‘black hole’ the government inherited, the basic level of funding for public services assumed by the previous government was inadequate even to hold per capita spend flat in real terms so this means the government finding substantial amounts of revenue if they’re going to address the crisis.

The government should start by raising taxes on those with the broadest shoulders. For example, research by the Centre for Analysis of Taxation has found that reforming capital gains tax, and equalising rates with income tax would raise £14 billion per year. While it would be great if government could raise the revenue needed by only taxing the small segments of the population who can most easily afford it, even with a number of these measures in place, the reality is that raising larger amounts requires turning to some of the bigger tax measures which are levied on a much larger section of the population.

If Labour were starting from a blank slate at this point (ie setting manifesto commitments to one side for now), there are several taxes – corporation tax, income tax, national insurance contributions, VAT – that could raise substantial revenues. However, none of these taxes are perfect and each comes with significant political and economic trade-offs. Picking the ‘right’ tax to increase is no simple question. From an economic perspective, IPPR’s framework for making such decisions would consider the following factors.

• Revenue raising power: The tax must raise substantial revenues, enough to fund significant amounts of day-to-day spending on public services.
• Cost of living impacts: The cost-of-living crisis is easing but not over and looms large in the minds of people across the country. After over a decade of stagnant earnings, many people across the UK are having to work harder just to stand still whilst a minority of wealthy households have done exceptionally well. The impact of any tax increase on peoples’ take-home pay and day-to-day costs should be a primary consideration, particularly the impact on lower- and middle-income households.
• Cost of doing business impacts: Labour has been clear that it aims to drive economic growth in partnership with the private sector. Business performance and growth are impacted by taxes. However, different taxes affect different parts of the business or the production process. We consider taxes on real production inputs (eg workers, materials, equipment, office/factory space) to be more harmful for growth than taxes that relate to the cost of capital. The conventional economic view is that the cost of capital is a significant determinant of investment and growth but as OECD estimates show, the UK has simultaneously had very low levels of private sector investment and lower capital costs than most other G7 countries. Analysis by the Resolution Foundation also shows that the rate of return on the UK’s capital stock has grown relative to other advanced economies in recent years.

• Macroeconomic growth impact: Different tax changes have different impacts on macroeconomic variables such as growth and inflation. Jung and Nanda (2021) highlighted that tax increases on workers have a much higher negative impact on short-term growth than taxes on business or investment. Megan Greene, external member of the monetary policy committee, has shown that household demand in the UK has been weak, particularly relative to the likes of the USA. At this current stage of the economic cycle, taxes that have a significant short-term macroeconomic impact could stem the demand growth needed to generate higher overall growth.

Table 1 below features an evaluation of different tax options based on our framework. It highlights the difficulty of the trade-offs faced by the chancellor – tax changes with minimal impacts on the cost of living, businesses and macroeconomic growth also raise less revenue.

IPPR’s preferred option from this table would be an increase in corporation tax, which would not have a direct impact on the cost of living. Since the introduction of full expensing on corporate investment, corporation tax now has much lower impact on private investment and the UK’s low capital costs relative to international competitors suggest that there is room to increase this without large disincentives to foreign direct investment. This means cost-of-doing-business and macroeconomic impacts are also likely to be limited. However, its revenue raising potential is not as high as other options – significant increases would be needed to make a real dent on public service funding needs.

There has been some speculation that the government may be looking to employer national insurance contributions (NICs) to fill the gap. There is some logic to pursuing this – it has large revenue raising potential and its potential negative effects are likely to be more modest than other options. The cost-of-living impact would not be immediate since take-home pay is not directly impacted. The Treasury has two options here: extend the tax on to employer pension contributions and/or increasing the tax rate employers must pay.

Extending employer NICs fully on to employer pension contributions would raise a substantial £14 billion according to the IFS, of which £6 billion would come from the top 10 per cent of earners. The short-term impact on the cost of living is likely to be very low – employers who pay above the minimum contribution are likely to absorb the cost through lower future contributions and employers who pay the minimum contribution are likely to reduce future pay growth. In either scenario, current take-home pay would be unaffected. Since most companies can pass on the costs through lower wages or pension contributions, the cost of doing business would not be impacted significantly. The exceptions would be employers in areas or sectors with labour shortages, who might find it more difficult to pass the tax on to employees. Given current macroeconomic and business conditions, this might be the more reasonable change to employer NI.

The impacts of an increase in employer NI rates on their own would be similar but felt slightly more immediately due to lower growth in take-home pay, rather than smaller pension pots. The OBR’s assessment of a now-cancelled 1 per cent increase in the rate of employer NICs during the Johnson administration judged that in the short-term employers would absorb 20 per cent of the additional costs associated with the tax, whilst passing on 80 per cent to employees through lower pay rises. This makes it preferable to simply reversing the NIC cuts on employees made by Jeremy Hunt. The cost of doing business impact is likely to be modest for a lot of larger employers but could pose issues for the growth of smaller businesses.

There are also challenges related to the treatment of public sector employer NICs – latest rumours suggest that public sector employers would receive extra funding for this, slightly reducing the revenue-raising power of either of these tax raising measures. If left unfunded, it would eat into some of the additional budget settlements which are the whole reason for tax increases in the first place.

But the overall impact of this budget on the cost of living, the cost of doing business or economic growth will not just come from tax measures – government spending is likely to have a positive impact. Whichever taxes the government chooses to raise, if the revenue raised from it is spent well this can mitigate or outweigh the potential impacts of tax rises. This can be true in the short-to-medium term as well as the longer-term – for example if reduced NHS waiting lists lead to increased labour market participation.

Tax rises may inevitably make the headlines, but both sides of the ledger matter – if increased revenue helps to ensure that public services can move out of crisis and begin the process of longer-term reform the overall package can be pro-growth and pro-worker. Our research also suggests that fixing public services is the most important political imperative facing this government - ‘fiscal responsibility’ without fixing public services will not be popular with voters.