Starmer and Reeves ditch plan to increase income tax rates in the Budget

Starmer and Reeves ditch plan to increase income tax rates in the Budget

The UK's Labour government, led by Prime Minister Keir Starmer and Chancellor Rachel Reeves, has publicly ruled out increasing income tax rates in its upcoming Budget. This policy decision forces the Treasury to explore alternative measures to address a fiscal gap estimated to be as large as £30 billion. The move signals a significant constraint on the government's fiscal options as it prepares its first major financial statement.

Context & What Changed

The United Kingdom's new Labour government has inherited a challenging economic landscape. Following the dual shocks of the COVID-19 pandemic and the subsequent energy price crisis, UK public sector net debt stands at approximately 99.8% of GDP (source: ons.gov.uk). Economic growth has been sluggish, and while inflation has moderated from its peak, the Bank of England remains cautious. The government came to power with significant public expectations for investment in strained public services, particularly the National Health Service (NHS) and education, alongside a commitment to fiscal responsibility and economic stability. This backdrop has created a structural tension between spending ambitions and the need to adhere to self-imposed fiscal rules, such as having debt fall as a percentage of GDP in the medium term. Independent bodies like the Institute for Fiscal Studies (IFS) have consistently highlighted a significant 'fiscal hole'—a gap between projected revenues under current tax policy and the cost of maintaining public services at their current levels, let alone improving them. The Financial Times article cites this gap as being potentially as large as £30 billion (source: ft.com).

What has fundamentally changed is the public and explicit renunciation of using income tax rate increases as a tool to close this fiscal gap. For a centre-left party, forgoing adjustments to the single largest source of government revenue—which raised over £250 billion in the last fiscal year (source: OBR)—is a profound strategic decision. It represents a deliberate move to reassure markets, businesses, and middle-income voters of the party's commitment to fiscal conservatism and stability, especially in the shadow of the market turmoil caused by the 2022 'mini-budget'. This self-imposed constraint forces the Chancellor to consider a narrower and potentially more politically complex menu of options, including less direct 'stealth' taxes, targeted levies on wealth and corporations, or significant spending cuts in unprotected government departments.

Stakeholders

UK Government (HM Treasury, No. 10 Downing Street): The primary actors, whose credibility now rests on their ability to formulate a coherent and arithmetically sound plan to manage public finances without resorting to a major, conventional revenue lever. They must balance market confidence with their political promises to the electorate.

UK Public and Taxpayers: While directly spared a rise in headline income tax rates, they remain exposed to other forms of fiscal consolidation. This includes 'fiscal drag' (where wage inflation pushes people into higher tax brackets), potential increases in other taxes (e.g., council tax), or a decline in the quality of public services due to funding constraints.

Businesses and Investors (Domestic & International): This group receives a mixed signal. The commitment to not raising income tax provides a degree of certainty and is broadly pro-business. However, significant uncertainty remains about the 'alternative' revenue-raising measures, which could include higher corporation taxes, windfall taxes, or changes to capital allowances, all of which directly impact investment decisions and corporate profitability.

Public Sector and Service Providers (NHS, Local Government): As the primary recipients of government expenditure, these stakeholders are highly vulnerable. The £30 billion fiscal challenge directly threatens their operational budgets. If the gap is closed primarily through spending restraint rather than revenue generation, unprotected departments face the prospect of significant real-terms cuts, impacting service delivery, public infrastructure maintenance, and employee headcount.

Financial Markets (Gilt Market, Sterling): Market participants will scrutinize the government's forthcoming Budget for a credible debt reduction plan. While ruling out tax hikes is intended to be market-friendly, any perception that the government's sums do not add up could lead to a negative reaction in the gilt market (i.e., higher borrowing costs) and pressure on the pound.

Opposition Parties: Political opponents will challenge the government on the specifics of its alternative plan, seeking to expose potential negative impacts on households and businesses, and highlighting any deviation from manifesto commitments.

Evidence & Data

The central figure is the estimated fiscal gap of 'up to £30bn' (source: ft.com). This aligns with analyses from think tanks like the Resolution Foundation and the IFS, which have estimated a required fiscal tightening of £20-£50 billion depending on the desired scope of public service provision and adherence to fiscal rules. The decision to forgo income tax hikes is significant given its scale; Income Tax, National Insurance Contributions (NICs), and Value Added Tax (VAT) together account for roughly two-thirds of all UK tax revenue (source: IFS). Ruling out increases to all three (the so-called 'triple lock' on taxes) severely limits options.

Potential alternative measures to bridge this gap, frequently discussed by economists and policy analysts, include:

Fiscal Drag: Continuing the freeze on personal tax thresholds. The OBR has previously estimated that the current multi-year freeze will raise over £25 billion annually by 2027-28, demonstrating its power as a stealth revenue-raiser (source: OBR).

Capital Gains Tax (CGT) Reform: Aligning CGT rates with income tax rates could raise an estimated £8 billion to £12 billion annually, though this figure is subject to behavioural changes (source: Resolution Foundation).

Pension Tax Relief Reform: Restricting tax relief on pension contributions for higher earners could generate several billion pounds, with estimates varying widely based on the specific policy design.

Windfall Taxes: Extending or expanding existing windfall taxes on the profits of energy companies or banks is a politically viable option, though the revenue generated is temporary and dependent on commodity prices and sector profitability.

Spending Restraint: The IFS has calculated that sticking to existing post-election spending plans implies real-terms cuts for many unprotected departments averaging over 3% per year, which would be extremely challenging to deliver without visible impacts on services.

This data illustrates that no single alternative measure can close the entire gap. A combination of fiscal drag, targeted tax changes, and some degree of spending restraint appears to be the most arithmetically plausible path.

Scenarios (3) with probabilities

Scenario 1: "Fiscal Drag & Targeted Levies" (Probability: 65%)

Description: The government's primary strategy involves relying on non-headline measures. The fiscal gap is predominantly closed by extending the freeze on income tax and other tax thresholds, allowing inflation and wage growth to increase tax receipts automatically. This is supplemented by specific, targeted tax increases on wealth and unearned income, such as reforming Capital Gains Tax and non-domicile status, and potentially further windfall taxes. To complete the consolidation, modest spending trims are applied to non-ringfenced departments, but core services like the NHS are protected.

Rationale: This represents the path of least immediate political resistance. Fiscal drag is less visible to the public than rate hikes. Levies on wealth and corporate windfalls are popular with the government's political base and are perceived as 'fairer'. This approach allows the government to claim it has not raised taxes on 'working people' while still undertaking significant fiscal tightening.

Scenario 2: "Growth Gambit & Deeper Spending Squeeze" (Probability: 25%)

Description: The government prioritizes a pro-growth agenda, arguing that supply-side reforms (e.g., planning liberalisation, investment in skills) will boost the UK's trend growth rate, thereby increasing tax revenues organically over the medium term. In the short term, to satisfy fiscal rules and market expectations, the Treasury implements deeper and more painful real-terms spending cuts to unprotected departments than outlined in Scenario 1. The bet is that future growth will allow for these cuts to be reversed later in the parliament.

Rationale: This scenario aligns with the government's 'pro-business' rhetoric. However, it is high-risk. The returns from supply-side reforms are uncertain and typically take years to materialize, while the political and social costs of deep public spending cuts are immediate and severe.

Scenario 3: "Forced U-Turn & Broad-Based Tax Rises" (Probability: 10%)

Description: A combination of deteriorating global economic conditions, lower-than-expected domestic growth, and a stark forecast from the OBR forces the government to abandon its pledge. Faced with a widening fiscal gap and the risk of a negative market reaction, the Chancellor performs a U-turn and announces broader tax increases. This could involve breaking the 'triple lock' pledge by raising VAT or National Insurance, arguing that exceptional circumstances necessitate a change of course.

Rationale: This is a crisis scenario. It would be politically devastating, shattering the government's reputation for economic competence and stability. It would only be undertaken if the alternative was perceived to be a full-blown fiscal crisis or an unacceptable collapse in public services.

Timelines

Short-Term (0-3 months): The period leading up to the first Budget will be characterized by intense media speculation and market positioning. HM Treasury will be engaged in detailed modelling of various tax and spending options. Government communication will focus on reassuring stakeholders of its commitment to fiscal discipline.

Medium-Term (3-18 months): The first Budget will be delivered, legislating the chosen fiscal strategy. The OBR will publish its independent forecast, which will be a critical moment of validation or challenge for the government's plans. The initial impacts of the chosen measures—whether tax changes or spending constraints—will begin to be felt by households, businesses, and public services.

Long-Term (18-60 months): The full economic and political consequences of the strategy will unfold. The success of the plan will be judged against key metrics: the debt-to-GDP ratio, the performance of public services, and the rate of economic growth. The government's fiscal credibility will be continuously reassessed by markets and voters, setting the stage for the next election cycle.

Quantified Ranges

Fiscal Gap to be Closed: £20 billion – £30 billion. The upper end of this range is cited in the source article, while the lower end reflects more optimistic growth assumptions.

Potential Annual Revenue from Key Alternatives (by end of parliament):

Extended Freeze on Tax Thresholds (Fiscal Drag): £5 billion – £10 billion in additional revenue per year, on top of existing freezes.

Capital Gains Tax Reform (aligning with income tax): £8 billion – £12 billion. The range reflects uncertainty about taxpayer behavioural response.

Pension Tax Relief Reform (restricting for high earners): £5 billion – £10 billion. Highly dependent on the specific mechanism chosen.

Unprotected Departmental Spending Cuts (real-terms): Each percentage point of annual reduction across unprotected departments saves approximately £2-3 billion per year.

These figures confirm that a multi-pronged approach combining several of these measures will be necessary to achieve a consolidation of £20-30 billion.

Risks & Mitigations

Risk 1: Insufficient Consolidation & Loss of Credibility: The package of alternative measures is deemed insufficient or non-credible by the OBR and financial markets, leading to higher government borrowing costs.

Mitigation: Ensure the first Budget presents a clear, fully-costed, and comprehensive plan. Front-load difficult decisions to demonstrate commitment. Maintain disciplined and consistent messaging from the Chancellor and Prime Minister, avoiding unfunded commitments.

Risk 2: Unintended Economic Consequences: The chosen tax measures, particularly those on capital and investment, deter private sector activity and depress economic growth, creating a negative feedback loop that worsens the fiscal position.

Mitigation: Phase in any new taxes on capital gradually. Accompany tax changes with a robust and credible package of supply-side reforms to boost productivity and investment. Engage in extensive consultation with industry before finalizing tax designs.

Risk 3: Severe Political Backlash: The reliance on 'stealth taxes' and spending cuts proves deeply unpopular with the public as households feel the squeeze on disposable incomes and witness a decline in public service quality.

Mitigation: Develop a strong public narrative that frames the decisions as necessary for long-term stability and fairness. Ensure high-visibility public services (NHS, schools) are demonstrably protected from the deepest cuts. Use targeted support for low-income households most affected by the changes.

Sector/Region Impacts

Financial Services & High-Net-Worth Individuals: This sector is the most likely target for alternative revenue measures. Changes to Capital Gains Tax, Inheritance Tax, and pension tax relief would directly impact wealth management, private equity, and the savings of high earners.

Public Sector: Unprotected government departments—such as Justice, Transport, and Local Government—are at the highest risk of significant real-terms budget cuts. This would impact public sector employment, infrastructure maintenance, and the delivery of local services.

Energy & Banking: These sectors remain prime candidates for further windfall or sector-specific taxes, given their recent high profitability and the political appeal of such levies.

Consumer & Retail: The continued impact of fiscal drag will constrain disposable incomes for millions of households, potentially dampening consumer spending and affecting the retail and hospitality sectors.

Regional Impact: Regions with a higher dependence on public sector employment and central government grants for local services will be disproportionately affected by a strategy reliant on spending cuts.

Recommendations & Outlook

Recommendations for Clients:

Public Sector Agencies: Immediately commence scenario planning for flat-cash or real-terms budget reductions over the next three to five years. Prioritize efficiency programs and develop robust, data-driven business cases for all future spending requests.

Infrastructure Investors and Operators: The government's commitment to major capital projects will be a key indicator of its growth strategy. Monitor the upcoming Budget for any changes to capital allowances or the introduction of new infrastructure levies that could affect project returns. Political risk analysis should be heightened.

Corporate CFOs and Boards: Assume a period of sustained fiscal tightening. Model the impact of continued fiscal drag on wage demands and consumer sentiment. Actively participate in Treasury consultations on potential changes to corporate, capital, and environmental taxes to shape policy outcomes.

Outlook:

The government’s decision to publicly box itself in by ruling out income tax hikes is a high-stakes move that defines the central challenge of its first term. The path of least resistance points towards a strategy of stealth taxes and targeted levies, as outlined in our primary scenario.
(Scenario-based assumption): We anticipate the upcoming Budget will heavily feature an extension of the freeze on tax thresholds, alongside concrete proposals for taxing capital gains and wealth more heavily. This will be paired with a narrative of ‘fairness’ and ‘making those with the broadest shoulders pay more’.
(Scenario-based assumption): The success of this strategy is contingent on economic growth not falling significantly below OBR forecasts. If growth disappoints, the fiscal arithmetic will become much more challenging, increasing the probability of deeper, more politically damaging spending cuts or a forced U-turn on broader taxes.
(Scenario-based assumption): The first Budget will be the defining moment. A credible, fully-costed plan will likely calm markets and provide a stable, albeit challenging, environment for businesses. Conversely, any perceived gaps or reliance on overly optimistic assumptions could trigger the very market instability the government is so keen to avoid.