How could Labour’s tax changes impact your finances?

Like many developed economies, the UK is facing challenges in raising the revenue its government needs to spend. Two key figures illustrate the problem, and they require some explanation.

Imagine your personal finances. You earn a steady income and try to keep your spending below it. If you overspend, you will become overdrawn.

The UK government faces a similar situation. It needs to balance its spending with tax revenue. When tax revenue falls short, the government borrows money, creating what’s called a budget deficit (around £120bn last year). This is like the amount by which the overdraft increases each year. The total overdraft, or accumulated deficits, is the national debt (now roughly £2.7tn).

These enormous numbers are hard to comprehend so we tend to express them as a percentage of Gross Domestic Product (GDP). GDP is the value of the total economic activity in a country. Think of it as the total income of all workers, landlords and businesses within an economy. This is a crude measure of things the government could tax.

The budget deficit in the 2023/24 financial year was around 4.4% of GDP^[1] and the national debt as a share of GDP was just under 100%^[2] in July 2024. But how do we know whether these are good, bad or indifferent numbers?

Will the country go bust?

Although we began by comparing household finances to public finances, for most major economies similarities are limited. When household debt rises, it can become unsustainable, leading to default and bankruptcy. For the UK, the chance of this seems remote.

In contrast, the government has discretion in setting tax rates to meet spending needs. Moreover, it creates the currency it uses. In extremes, the government can find pounds to meet public spending if it wants to, even if it had to resort to “printing” it.

While excessive government debt is a concern, it’s more likely to manifest as currency devaluation or inflation, which might need to be countered by rising interest rates. This affects savers, as inflation erodes the value of their savings.

Accumulating debt also increases the amount of interest the nation must pay, making it difficult to avoid further debt.

Are tough choices really required?

The UK government faces tough decisions, but there’s nuance to consider.

The government sensibly constrains itself by the fiscal rule that requires debt as a share of GDP to fall by the end of the Office of Budget Responsibility’s (OBR) five-year forecast period. Fortunately, the government is on track to meet this target.

However, there’s a catch.

Every year there’s a new final year of the forecast period. It’s possible to meet the rule by always expecting to cut borrowing in five years, while increasing borrowing in the current year. “Lord, give me chastity and continence, but not yet!” as Saint Augustine says in his confessions.

For example, the OBR has noted that the government has consistently frozen fuel duty rates since 2011, despite previously planned increases. This has resulted in a significant deviation from the original fiscal plans.

Additionally, the forecasts restrict spending growth, while protecting certain departments like health, education and defence. This implies sharp reductions in spending on other departments, like transport and justice, which many consider implausible.

Is there a third way?

It seems then that some hard choices will be taken, but a third path may exist.

While it’s assumed it’ll increase taxation and could potentially cut spending, the government could focus on increasing potential GDP. 

Increasing GDP without changing tax rates produces more revenue. To some extent this formed part of the approach taken by Liz Truss during her brief premiership. Whilst that doesn’t bode well as it caused a sharp increase in interest rates, the current economic context is different.

Firstly, the economy was operating at or beyond full employment back then, meaning that attempts to stimulate the economy were more likely to trigger inflation than growth. Currently, there’s perhaps more scope for non-inflationary growth.

Secondly, the current government has taken steps to demonstrate fiscal responsibility, building back confidence in the UK’s economic credibility following the 2022 ‘mini-budget’ under Liz Truss. This may afford Labour more license to borrow and spend wisely.

In this context, the government could consider adjusting the fiscal rules to exclude investment spending. This could boost taxable economic activity in the future, rather than being constrained by a current rule that doesn’t differentiate between current spending and investment spending (2.6 percentage points of the UK’s 4.4% budget deficit reflected investment spending last year)^[3].

But what kind of projects won’t go ahead because of this restriction? Well, it limits the ability of departments to invest in systems and infrastructure which might increase efficiency and reduce cost in the future. Every governmental department could benefit from investment in its physical digital resources to help staff work efficiently.

So far, the government has seemed committed to abiding by the previous administration’s fiscal rules, which may not be the most effective approach. A more relaxed attitude towards investment expenditure, combined with a more demanding rule on current expenditure, might be a more suitable strategy.

If the deficit must be reduced, how can the government do it?

The government has added to its fiscal constraints by promising not to raise certain taxes, including income tax, corporation tax, National Insurance (NI) and VAT, as per its manifesto. It has also discussed not raising taxes on working people, a phrase which is as ambiguous as it is meaningful.

Where could the government look?

As we age, many of us rely on our pensions to provide a comfortable retirement. However, the UK’s pension system is complex and has been criticised for being unfair and inefficient. The government is considering reforms to make it more sustainable and equitable, but all proposals have either economic or political costs.

Pensions are costly for any serving government because they offer tax relief on contributions (public cost) now, but then charge tax on withdrawals (public revenue) in the distant future. One proposal is to restrict up-front income tax relief to the basic rate of income tax or a flat rate of income tax for all. George Osborne even suggested making pensions like ISAs, with no tax relief on contributions but tax-free withdrawals.

The political appeal is clear, but incomplete tax relief would effectively mean higher earners would pay tax on both contributions and withdrawals, which seems a perverse disincentive to save for retirement.

The pension tax-free lump sum benefit could be limited to a fixed amount, reducing its benefit, particularly to wealth investors. However, this approach could be unfair to savers who have planned their finances based on this payment. 

Could NI be applied to pensions?

Currently employer pension contributions and pension income are free of National Insurance Contributions (NICs) (both employer and employee). These tax efficiencies could be targeted by the government, raising questions about its manifesto commitment to not raise NI.

To avoid undermining the public trust in pensions, fundamental reforms of the type discussed above could require savers to differentiate between their existing pensions and new pensions, contributed to on different terms. This would create more complexity.

Because of these challenges, some of the most significant reforms to pensions have been additional freedoms on the use of proceeds, but more tellingly, restrictions on the amount that can be contributed and the total size of the pension pot. A compensatory increase in the ISA allowance has led savers to accumulate wealth in tax-free ISAs, which will mean less taxable income as people start drawing from their ISAs.

ISAs have also taken on more importance for funding retirement because a huge benefit of saving into pensions comes from the fact that bequeathed pension wealth does not form part of the investors’ estate. For example, if a saver dies before 75, their pension can be inherited with no further tax due on the income.

Removing these benefits would create revenue for the public finances, but at a cost. Many families might find themselves better off accumulating wealth in other tax-free wrappers, rather than their pensions. This would be a difficult political decision for the government – taxes on inherited wealth are a divisive and unpopular concept.

The same dilemma would arise if the chancellor was to remove the exemption from capital gains tax (CGT) on death.

Is capital gains tax the obvious golden goose?

CGT has been the focus of much speculation about raising tax revenues.

The Labour Party see CGT as a way to redistribute income, but also recognises the importance of not discouraging investment through excessive tax on capital gains. Raising CGT rates to match income tax rates would effectively close the fiscal hole, but the numbers don’t tell the full story.

CGT is a tax that affords the payer some discretion over whether to sell an asset and trigger a liability. Therefore, if tax rates rise sharply, there would be a reduction in transactions, significantly decreasing revenue.

How significant would this be?

According to government estimates, equalising the tax rates would actually decrease revenue significantly rather than increasing it. There are plenty of other reasons why the government should be wary of increasing CGT rates sharply, but that seems the most compelling.

Of course, that effect could be temporarily overridden by signalling the change in enough time to prompt a rush of liquidations from investors getting ahead of the change, providing a short-lived boost to the public finances.

Could the chancellor’s refusal to rule out a CGT increase be an act of subtle coercion? Maybe, or perhaps that’s just wishful thinking!

Maintaining frozen thresholds

A final means of increasing tax take is to continue freezing allowances. This is essentially how the previous government were able to increase the tax burden whilst not increasing tax rates. This approach allows tax rates to remain steady while incomes grow, causing taxpayers to naturally move into higher income categories and be subject to higher tax rates – a move that wouldn’t breach manifesto promises.

Pre-Halloween pain ahead?

We don’t know how the new government will raise new tax revenue, but it seems almost certain it will. There are a lot of different ways it could do so, and there’s an overarching desire to make the tax system simpler and easier to understand.

However, it seems wishful thinking that the Budget won’t add to the complexity, as governments try to make their acts of generosity more obvious than their acts of austerity.

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[1] House of Commons Library, September 2024

[2] Office for National Statistics, August 2024

[3] Office for National Statistics, August 2024

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