New chancellor will get growth from tax reform rather than tax rises

Speculation remains rife surrounding the identity of the next UK Chancellor. The incumbent, Rachel Reeves, looks unlikely to survive the change in Prime Minister. This is despite her relative favorability amongst the UK government’s creditors in the bond markets. A summer clear-out at Number 11 Downing Street now looks all but guaranteed.

Ed Miliband, Wes Streeting, Yvette Cooper and Shabana Mahmood are all being considered as alternatives by Prime Minister-elect, Andy Burnham. However, this debate on the identity of the Chancellor risks obscuring the fact that the economic challenges will remain unaltered whoever takes charge at the Treasury. The idea that the economic malaise of the UK economy might be solved by a change in personality is a comforting thought. It is also naïve, and wholly wrong.

Rachel Reeves will not lose her job due to a lack of understanding of the deep-seated issues faced by the UK economy. In my experience, Reeves understands these as well as any of her predecessors. She will lose the Chancellorship because her own political party, like the Conservatives before them, are not facing up to difficult trade-offs required to raise UK living standards and economic growth. This challenge is almost certainly bigger than one woman, or man. It requires a whole mindset change. Economic growth has been an afterthought to economic virtue signaling for at least two decades. A more hard-nosed approach to the tradeoffs inherent in economic policy is required if UK living standards are not to fall further behind those of our nearest peers.

The next Chancellor will have to face some sobering economic facts. And neither a smooth media voice, nor previous Treasury experience will alter how these facts will shape the rest of the Parliament.

Firstly, the UK tax rate is heading to an eighty-year high by the end of the decade. The level of tax, combined with its incidence on a shrinking group of taxpayers and companies throws in an additional risk of overconcentration on firms and individuals with choices on where they locate, and live.

Secondly, public sector debt as a share of national income is now at a sixty-five year high. The pensions industry, for a long time happy to mop up large quantities of this debt, is no longer a cornerstone buyer. This has contributed to pushing the interest rate on that debt to the highest in the G7.

Thirdly, UK inflation has averaged 3.0% since 2010. A series of policies such as the National Living Wage, the pursuit of Net Zero, and overzealous building regulations having made the UK an international outlier in its cost of employment, its cost of energy, and its cost of construction. The Bank of England’s policy of higher interest rates is like pushing water uphill if governments continue to layer on additional costs to produce goods and services in the UK.

Fourthly, with the government spending 2.6% of GDP on defence and 10.6% of GDP on social security the allocation of resources doesn’t look “match fit” to protect the UK’s international interests, and to spawn frontier technology of huge economic potential. This Western European malaise is why President Trump’s America can dictate terms on issues like cross-border taxation of US technology firms.

That Rachel Reeves had the misfortune to inherit these four features of the UK economy - which have their origins long before she took office - does not excuse some contemporary missteps. In particular, she must surely regret a couple of key decisions that made a tough job harder. First, the crushing of animal spirits in the immediate aftermath of the 2024 General Election. Repeated talk of a £22bn fiscal black hole may have successfully pinned political blame on the Conservatives. But it also pierced business and consumer confidence that was recovering strongly in early 2024. Second, the decision to increase employer National Insurance contributions by £25bn a year from April 2025 clearly caused a slowdown in hiring, and triggered an increase in domestic inflation. That decision on tax spoke to the political naivety of the tax lock pledge in the 2024 Labour manifesto.

No-one serious in UK economic circles felt that Labour (or Conservative) pledges on tax and spending made in 2024 were remotely achievable. So it has proven. The idea that significant amounts of tax revenue now lie waiting for a new Chancellor prepared to raise capital and wealth levies is a similar idea that won’t survive contact with the realities of a modern, open, market economy.

So, when looking at the identity of the new Chancellor, financial markets will be seeking four virtues.

First, will a new Chancellor begin the reverse journey towards abundant and competitive energy, building, and capital. Manchesterism – the idea that the impediments to this abundance have been a complex regulatory and financing model - is an interesting vision around which a new Chancellor may coalesce with Andy Burnham. But markets will need convincing this is an agenda for supply side efficiency, not a smokescreen for nationalisation.

Second, fiscal devolution. Fines should be handed out for lazy use of the phrase “Treasury View” when considering why the UK has not yet pursued wholesale fiscal devolution – beyond the fiscal powers accorded to the Scottish Parliament. The Treasury are rightly concerned that devolution of fiscal rights, without fiscal responsibilities – that include local leaders owning the full responsibility for any fiscal mismanagement - would lead to investors concluding this is path to higher central government borrowing. UK debt would become more expensive. A proper framework for fiscal devolution is the pre-requisite here, not culture wars at the Treasury.

Third, the UK’s tax system remains covered with barnacles that often make employing a good accountant a more lucrative endeavour for UK businesses than developing a new product for sale. There are tax reforms aplenty - supported by all sides of the political spectrum - that could generate more efficient markets in land, capital and employment. Reform of taxes like Stamp Duty, Council Tax and VAT have been a pro-growth initiatives allowed to sit idle for decades. A tax-reforming Chancellor will surely get a better growth dividend than a tax-raising Chancellor.

Fourth, if the existing fiscal rules are to be once again revised to facilitate more public investment, then a new Chancellor will need to bury the suspicion that this is to avoid difficult decisions on current spending - particularly welfare - or to fund inflation-busting pubic sector pay awards. A more accommodative investment rule might require a tightening of the current spending rule to avoid financial markets demanding ever higher interest rates to lend to the UK government.

Investors I have spoken to over the last week do not yet know where Andy Burnham and any potential replacement Chancellor sit on these issues. Upcoming speeches may help fill in the gaps. But as Rachel Reeves has found out, actions always speak louder than words.