Squaring the circle

With interest rates on Government debt having risen sharply, high inflation and low growth, the Labour Party is reluctant to make ambitious fiscal commitments.  Yet UK Labour must demonstrate the difference Labour makes in power so that Scottish Labour can go into the Holyrood elections with a powerful message of change.

Governments have in general three measures for additional funding;

1. Money creation
2. Borrowing
3. Taxation

Creating Money

Since the 2008 financial crisis, the independent Bank of England has exercised its power to create money through quantitative easing (QE), thus injecting vast sums into the economy. This involves buying government bonds, increasing their price and reducing their interest rate, and also buying assets and equity to push up value and create a “wealth effect”.

However, the Bank has expressed a desire to reverse QE. Interfering with this decision, and with the Bank’s independence, could spark instability and worsen inflation, already at recent highs, as well as hindering much-needed improvements in investment, which has been a missing piece of the UK’s economic puzzle over the past 13 years.

The “money creation” option, therefore, seems to be a dead end for now.

Borrowing

The effectiveness of borrowing hinges on a reasonable return on investment. Borrowing at 1% interest to invest in a business with a 10% return, for instance, is a win-win scenario. However, Liz Truss’ attempt as PM in September 2022 to increase borrowing met with understandable scepticism from lenders who doubted the credibility of proposed tax cuts and their ability to generate growth. Interest rates on government debt are far higher than they were even a year ago.

Labour has committed to borrowing for investment, not routine spending. This strategy will likely fund the build-up to £28bn per annum spending on the green economy by the end of its first term. One option is for Labour to broaden its definition of “investment” to include areas like education, in which we invest in the human capital of the future workforce. This would facilitate more borrowing without violating the party’s fiscal rules. When interest rates come down, as they are due to in the coming few years, this option becomes more credible – but may not be enough on its own.

Taxation

Raising taxes is the obvious solution. Labour has promised a windfall tax, VAT exemptions removal on private schools and ending non-dom status. However, these measures, although commendable, would not generate enough revenue for transformative change. A windfall tax is by definition a one-off, and so can be used for immediate relief but not long-term increases in spending. The removal of VAT exemptions on private schools would raise an estimated £1.6bn per year and the removal of non-dom status around £3.5bn per year. For context, spending by the UK Government on healthcare was estimated to be £229bn in 2021.

Labour could be bolder on taxation and I would suggest;

• Wealth Tax: A 1% annual tax on wealth exceeding £10m could potentially generate an extra £10bn annually, according to the Institute for Fiscal Studies. The problem of course is finding this wealth. It is likely that action would need to be taken on off-shoring, and also global co-operation to create a minimum tax rate on wealth. Labour should work with the USA and the EU on this if there is a sympathetic US administration going forward.

The IFS notes that the administrative costs would be prohibitive if the threshold were low, because there is a large cost to calculating the value of taxable wealth. But at higher threshold (such as £10m), the proportion of the population affected is so small that the administration costs would be low.

• Land Value Tax: Taxing the owners of large areas of unprotected, undeveloped and unused land, where there are no plans for development, could drive investment and entrepreneurialism with land, helping address crises like housing and energy. Economist Martin Wolf of the Financial Times is a supporter. This paper by the CEPR argues that increasing taxes on land value and using this to cut taxes on labour and capital could increase output by 15% relative to trend. An alternative might be to value land more accurately and then use existing taxes on it. This could include council tax reform to make it more progressive.

There is also the possibility of removing some tax reliefs to increase revenue, but as yet it is unknown how many could be removed and how much revenue they would create.

By expanding the definition of “investment” and executing well-crafted new taxes, Labour could increase revenue and spending, rebalance taxes between income, capital and land, and foster a fairer system for hard-pressed working individuals.

There is an alternative to the three options above, but it’s not easy. It involves economic growth without excessive spending, using changes in regulations, rules, and competition policy to boost investment and reform to public services to boost productivity. Our intention is to publish a separate article on this option. Whichever option Labour chooses, improvement will take time, as Labour will inherit a disastrous economic situation rather than the relatively benign environment of 1997.

History has shown us that the politics of change comes at a cost, or as economists call it “opportunity cost”, and we need to prioritise. This cost is usually compounded with tough decision making in often challenging circumstances in both practical and policy terms. Labour must think creatively and holistically to develop policies capable of revolutionizing the UK economy, achieving the highest growth in the G7, removing barriers to opportunity, and restoring world-class public services. The path to accomplishing will not be easy but this lies in our collective, imaginative policymaking, and our  commitment to public services.