A view from London

Much of the commentary since the election has focused on the difficulties facing the new government. The UK today is a far removed from the high growth, low tax economy that Tony Blair’s Labour government inherited from the Conservatives in 1997. Before turning to the challenges facing the new government, we should consider the positives.

First, the UK and EU economies are recovering after a sustained period of weakness. The UK’s brief, shallow recession ended in the first quarter of this year with a blistering 0.7% increase in GDP, far faster than in any G7 economy. That is likely to prove a one-off, but we expect UK growth to run at around trend, or normal rates, for the rest of this year and through next. Inflation hit growth and spending power in the last couple of years but is now in retreat. From a late 2022 peak of 11.1% inflation fell to just 2.0% in May. With earnings increasing by almost 6.0% year on year, real household incomes are rising rapidly for the first time since the economy bounced back from the pandemic in 2021.

Second, the new government is unlikely to have to deal with the magnitude of the problems that afflicted the UK in the last parliament. The pandemic, the invasion of Ukraine, the energy crisis and the ensuing surge in inflation represent the greatest threats to growth and stability since the war. The next five years will bring shocks, but the new government would be exceptionally unlucky to find itself grappling with the scale of the problems that beset its predecessor.

Third, with Labour’s landslide parliamentary majority and the swift transfer of power the election is likely to pave the way for a period of relative political stability. This is in contrast to the situation in the US ahead of the elections on 5 November and, in the wake of the European elections, in continental Europe. No one expects a repeat of the UK’s three prime minister record of the last parliament.  

Labour’s opportunity is that it comes to office after a period of exceptionally poor economic performance and as the economy is finally turning up. It is a measure of the weakness of the UK economy that it has underperformed even Italy, the growth laggard of Europe, since 2019. In the last parliament UK GDP grew by just 1.7% while real incomes were actually lower in early 2024 than they were in late 2019.

Assuming an absence of large external shocks it should not be hard to better this over the next five years.

We should not underestimate the restorative power of sustained economic growth. If the UK could sustain growth of even 1.3% over the lifetime of this parliament the economy would be almost 7% bigger in five years’ time than today.

This is not an argument for complacency. Events may yet derail growth. A return to 1.3% growth will not achieve the new government’s aims and is unlikely to meet public expectations. Labour wants to raise the UK’s growth rate substantially, partly in order to repair what Sir Keir Starmer described as Britain’s “broken” public services.

In a recent interview with the Financial Times, Ms Reeves described growth as “the only way out of this mess” and rejected the idea of a major increase in public spending funded by debt or taxes: “Borrowing more is not an alternative because debt as a share of GDP is the highest it’s been since the 1960s” while raising taxes was “not an alternative because tax is already at a 70-year high”.

This would seem to preclude the sort of big fiscal easing undertaken by the Biden administration through debt-funded spending on infrastructure, renewables and semiconductors.

Labour plans relatively modest tax rises, yielding just under £9bn. According to the manifesto, this will be funded through reduced tax avoidance, changes to the taxation of UK non-domiciled residents, applying VAT to independent school fees, a windfall tax on oil and gas companies and a higher tax rate for private equity carried interest. Labour also plans a small increase in public borrowing of £3.5bn.

£9bn of tax rises and £3.5bn of borrowing would give the new government just £12bn of extra public expenditure, small beer when total public expenditure is running at £1,226bn. Revealingly, most of the extra money, £7.3bn, has been earmarked for current spending, on the NHS, social care and schools.

That leaves just £5bn for spending designed to raise growth – a ‘Green Prosperity Fund’ including the creation of a publicly-owned company, Great British Energy, and a National Wealth Fund tasked with investing in green energy, infrastructure and industry. Great British Energy and the National Wealth Fund would aim to attract private sector capital to investment alongside public funds. 

Other elements in Labour’s growth plan would come at little or no cost to the exchequer – reform of the planning system to increase levels of housebuilding, improving UK-EU trade relations (though not rejoining either the Single Market or the Customs Union), greater devolution and increased coordination between Westminster and the nations and regions of the UK.  

Arguably the most radical element in Labour’s manifesto relates to the Party’s commitment to a “new deal for working people”. Labour aims to increase workers’ rights and job security with a sweeping set of reforms. Probably the most significant would be to give employees protection against unfair dismissal from the first day of employment. Currently, in most cases, eligibility is limited to those who have worked for an employer for at least two years. Critics warn that the proposal could make employers, especially smaller companies, wary of taking on staff. Labour says that employers would still be able to dismiss staff during a probationary period and that it plans to consult on these and other employment proposals.

In its analysis of Labour proposals to expand some benefits, including statutory sick pay and maternity pay, the Institute for Fiscal Studies argues on the basis of previous such reforms much or all of the costs would be borne by employees in the form of lower wages. The IFS acknowledges the potential benefits of raising benefits but cautions that, these policies are “not a free lunch for workers”.  

One of the many challenges for the new government will be to increase employment protection in a way that does not weigh on job creation and productivity.

There is probably scope for Ms Reeves to raise public expenditure beyond her current plans. Labour’s current commitment to hold the rates of income tax, national insurance, VAT and corporation tax and not to “increase taxes on working people” would arguably not preclude extending the scope of VAT, raising capital gains tax, inheritance tax or, perhaps, even council tax. It would also be possible to impose windfall taxes on banks or other companies or increase taxes on pensions.

The problem is that taxes are already at the highest as a share of GDP since 1949 and, even before Labour’s planned tax increases of £8.6bn, are due to rise by a further £23.5bn due to the decision by the previous chancellor to freeze personal allowances until 2027/28. Ms Reeves has given no indication that she plans to row back from her predecessor’s commitment. The UK is not the low-tax economy it was when Labour last won a landslide, back in 1997.

Ms Reeves could also consider some easing of the fiscal rules, perhaps to allow greater borrowing for investment. Writing in the Financial Times the former chief economist of the Bank of England, Andy Haldane, argued for just such a change saying that, “existing fiscal rules risk starving the economy of the very investment needed to boost medium-term growth”. But with public debt running at around 100% of GDP, the highest level in 60 years, Ms Reeves scope for further increasing levels of public sector borrowing seems relatively limited.

Despite high levels of public spending, dissatisfaction with public services is rife. The extra £7bn of public spending Labour plans on services is dwarfed by £18bn of cuts to so-called non-protected spending departments, such as transport, justice and local government, already baked into the fiscal arithmetic by the previous chancellor. One of many decisions Ms Reeves will have to make in her budget in September or October will be whether to go ahead with those spending cuts. No wonder that Sir Keir Starmer warns that repairing public services will take time.

A more stable domestic environment, an absence of big shocks and a recovering economy should all help the new government. But to improve public services and incomes without big increases in taxes or borrowing, Labour needs faster growth. That is a worthy, but daunting goal.