Labour's constraints

And how to find an escape hatch

What do social democrats do when the money has run out? After the financial crash this was a common question for those on the centre-left.

Broadly speaking, the debate split into two camps. The first contested the assumption (and the metaphor) that the government’s credit card was maxed out. Instead, borrow more, while interest rates are ultra low, and remedy the under-investment in infrastructure that could fuel productivity growth.

The second camp suggested social democrats ought to focus on different ways of achieving their goals. Rather than correcting the inequalities thrown up by the market through the tax and welfare system, the state should shape the structure of the economy and labour market. During Ed Miliband’s leadership, for example, he argued for a focus on ‘pre-distribution’, and shifting the pattern of rewards accruing to people through wages. (Indeed, this is sort of what George Osborne did after 2015 with the significant increases in the minimum wage).

Today, as departments scramble for funds in a grim spending review, the question of what to do with no money haunts Labour again. The government faces unprecedented demands - to increase defence costs, invest in infrastructure, including net zero, while also increasing NHS funding and avoiding social care, prisons, or universities falling over. All of this, without the cheap cost of capital bequeathed by the response to the financial crash.

Source: Institute for Fiscal Studies

On the other side of the ledger, the government is boxed in politically and financially from every direction. Its room for manoeuvre on taxation and borrowing is limited. Economic growth is the ultimate way to fix public finances, but the two cheapest ways to improve the economy through higher migration and improved EU relations are hard to navigate.

When you list out the five key constraints, you cannot help come to the conclusion that the government will need to find more than one escape hatch:

1. No major tax increases: Before the election, Labour ruled out increasing the rate of income tax, national insurance and VAT. The Chancellor has continued to restate this position when pushed.

2. No additional borrowing through changes to fiscal rules: Reeves has already changed the rules once and she's said that is it for the Parliament.

3. Cutting regulation on business: Starmer announced he would cut regulation on business by 25%. While regulatory constraints, particularly on building new homes and infrastructure, are worth going at hard, regulation is one of the few things a government can meaningfully do that doesn't cost money.

4. Reducing net migration: Migration is one of the few policies that generates economic growth and higher tax revenues, in the short-term, at little cost. For example, the OBR assumed last year that an increase of 350,000 net migrants would produce a net reduction in borrowing of around £7.4bn by 2028-29. That’s equivalent to almost a penny off the basic rate of income tax.

5. EU Red lines: As well as ruling out re-joining the EU, Labour also ruled out single market or customs union membership, and freedom of movement. While it is seeking a reset, the fundamental Brexit settlement will remain intact.

Although it was short-termist, it is understandable that Labour ended up with these commitments. The party won a handsome majority but a small vote share. Reducing the three main sources of right-wing attack - on migration, the EU, and tax rises - stored up trouble for the government, but was probably seen as critical to victory. On the fiscal rules, the Autumn statement broadened the definition of debt for its fiscal target, but who knows how the markets would have reacted to an even broader definition.

If Labour leaves these constraints in place however, it will be forced to muddle through. If today's politics is about painting in bold primary colours, Labour’s constraints leave it sketching in faint pencil lines. Their only hope might be that Trump generates cheaper energy prices, from some sort of peace between Russia and Ukraine, and abandons his tariff war.

Options ahead

So what should the Government do? I’d suggest the following as ambitious but realistic end-points.

1. Raise cash by flexing fiscal rules and new hypothecated taxes

On taxation, I suspect the government will need to find a way to raise an additional £25 to £30 billion per year, which would amount to a 3% increase in the total tax revenue of £857 billion.

A simple and fair way to do this would be to raise income tax by 3 pence. One way to legitimise these increases would be to earmark any additional taxes as an ‘NHS levy’ or ‘Defense levy’.

A more radical version would be to take NHS spending out of income tax altogether, and create a hypothecated tax that funds the whole of NHS spending, on the basis that this is the one area of taxation where there might be the largest public support for future increases. This could be accompanied by an NHS report card, explaining where the money goes, and what it delivers.

There are technical challenges in that income tax revenues are affected by economic growth, which might create volatility if this was the only source of tax revenue for the NHS. But there are ways of creating buffers, for example, by banking higher than expected revenue, and borrowing in weaker years.

On the fiscal rules, it might create some headroom by changing the Bank of England classification of the Term Funding Scheme, which is currently treated as a public sector liability. The IFS estimated that reclassifying it in March 20204 could reduce headline debt and create £16 billion in additional fiscal space.

The government should also look at where it can apply the flexibilities it generated through the last fiscal rule change. For example, if the UK government co-invested in new offshore wind farms alongside private investors, there is a guaranteed revenue stream through a Contract for Difference, so this ought to be exactly the kind of investment which is classified as an asset.

The normal way the government makes decisions on taxes and fiscal rules is to do so in secret, and pull a rabbit from the hat at a fiscal event. This often doesn’t work very well, as budgets get good headlines on day one, before unravelling later (pasty tax anyone?)

An alternative would be to use the typical device favoured by many Chancellors: create a review. An external figure charged with looking at the pressures on public finances, and setting out options, both for higher taxes and any adjustments to the fiscal rules, would allow more radical ideas to be developed and tested. Taxation is the one area of policy that is the least consultative and most closed, but that produces bad policy. If the government was really brave, they could even use the tax calculator we produced with the IFS (version 2 out soon) to launch a deliberative process off the back of the review.

2. Remove the political barriers to growth

On economic growth, similarly radical thinking is needed. From what I hear, there is a risk that no team within government has the mandate to think of radical options from first principles and without political constraints. Radical options can always be taken off the table, but it’s a helpful discipline to quantify the trade-offs so that decision-makers can then assess whether it is worth spending political capital on big ideas. In the absence of a Prime Minister’s Strategy Unit, a joint team from HMT and No10 should be set up to do this.

They should be charged with putting all options on the table - even those that seem politically unattractive, such as having higher migration rates than the home office would like, closer EU ties, or weaker environmental regulations. If processes take these off the table immediately - either because a department will not cooperate and share the right data, or political teams worry about leaks - you never find the productive tension between policy and politics.

Migration is a particularly good example of this challenge, not least because nobody trusts the underlying ONS data - it’s prone to major revisions and undershooting its forecasts. What is clear is that the fiscal contribution made by migrants varies significantly by age and skill level. The debate on migration should focus less on the overall numbers, but more on the composition. As I’ve argued before, it should rebuild the case for a higher number of high skill migrants, and be prepared (as seems likely) to do a deal with Europe on a EU youth mobility scheme.

3. Bolder regulatory reform

On regulation, red-tape has been elevated as a major constraint on economic growth. The conversation is overly-simplistic. The government will need to be more aggressive in removing regulation in some areas, but bolder in introducing regulation in others. Deregulation cannot be a governing philosophy.

I’m sure there will be some bold sounding rhetoric on planning, but it should ask the question: what is the cost and time of actually building a house or bridge or pylon, from end to end? Then measure the additional time and cost we are adding on through the planning and approvals process, and then assess the degree to which any policy change is radically cutting this ratio. This is a classic case where the policy conversation needs to be disciplined by numbers not adjectives, and a sense of what it would take to get to a given goal, rather than just be seen presentationally to be doing something in this space (the usual bar for comms-driven policy).

In addition to one-off changes to the planning regime, I also wonder whether they can take a test-and-learn approach. It could pick a series of priority projects - including strategic infrastructure - and establish a small, cross-government team for each project, with a mandate to cut the time to build. As well as speeding up those specific projects, the teams would be responsible for finding blockers that hold back similar projects and then reverse engineering policy changes to remove them. The government has made big progress on planning over the last 9 months, but those looking to block or stop projects are not going to just admit defeat - they will find new ways to raise objections. And the government must keep tweaking and changing the system in response if it wants to deliver its goals. It's a bit like what the Johnson government did with Project SPEED, but instead of focusing solely on massive national infrastructure priorities, it can keep the wider planning system more dynamic.

Alongside this, there are areas where it should be prepared to regulate harder, particularly when the potential to tax or subsidise is limited. Clear, long term, outcome based regulation can drive innovation. It’s also a lot cheaper than complex subsidies, or attempts at micro-managing business through process based regulation

For example, carbon taxes or taxes on sugar and salt may raise consumer bills, and generate economic rents. Regulation is an alternative that avoids this - and was used very effectively to accelerate the deployment of condensing boilers and more efficient lighting and appliances, as well reducing salt intake in the 2000s.

The current regulatory edict announced by the PM is being seen as just another hurdle for policymakers to jump over. Instead of a reactive approach, the government could lead a series of sectoral, or mission-based regulatory reviews that define the right regulatory approach for each area. While we might want to see a general push towards more outcome-based regulation in place of practice-based regulation, I suspect each sector will require quite different approaches. With AI, for example, we might need more transparency and powers for regulators to step in to avoid regulatory structures that either intervene too early pre-emptively or too late after harm has been done and costs escalated. We need a smarter conversation on regulation which is more about smart versus dumb, rather than more versus less.

More reviews

Solving a policy problem, by creating a series of new reviews or further processes, feels like a typical civil servant approach to policy. A bit like concluding at the end of a meeting that we need another meeting. But I cannot see the kind of radical changes required emerging in the next budget, or the one after that, unless the process of policy making is opened up. Radical change usually requires some advanced signalling, and resetting the table.

What I’m reading

I’ve mainly been absorbed in Liverpool commentary in the last few days, and rather belatedly ordered this book by Ian Graham on the data nerds behind Liverpool's success a few years ago.

And while we’re on the subject of Liverpool, and with Mo Salah’s contract extension still fresh in the memory, this gives me the perfect excuse to share an excellent paper co-authored by a former colleague Salma Moussa. It explores how exposure to celebrities like the ‘Egyptian King’ can reduce prejudice towards minorities, through something called ‘parasocial contact theory’.

Key fact from the paper: “Using data on hate crime reports throughout England and 15 million tweets from British soccer fans, we find that after Salah joined Liverpool F.C., hate crimes in the Liverpool area dropped by 16% compared with a synthetic control, and Liverpool F.C. fans halved their rates of posting anti-Muslim tweets relative to fans of other top-flight clubs.”