Macro Moments Weekly: The Search for UK Growth—Burnham's Odyssey

Key takeaways:

• Higher taxes are likely to weaken growth in the short term: Economic evidence suggests that increases in income and business taxation tend to reduce investment, employment and household spending, with the UK's recent tax rises particularly focused on growth-sensitive areas.
• What matters is how the money is spent: Taxes used to fund day-to-day consumption and transfer payments offer limited economic returns, while investment in infrastructure, housing, skills, technology and energy networks can boost long-term productivity and growth.
• Britain faces a narrow fiscal path: With debt already high and future spending pressures rising, the next government will need to balance fiscal credibility with growth-enhancing investment, a difficult task requiring both political courage and market confidence.

The economic debate in the United Kingdom since COVID-19 has been very similar to that of the 1970s: Are high taxes stopping growth? In the 1970s, taxes peaked at 35% of gross domestic product (GDP), but we are now above that level and heading towards a tax burden previously seen only in wartime. The Office for Budget Responsibility (OBR) shows they are set to rise. In 2024, they were at 34.5%; today, they are at 36.3% and are projected to be at 38.5% in 2030/2031.¹ The rise in taxation under Starmer and Reeves is truly unprecedented and is turning the United Kingdom into a high-tax country. What hope is there for growth with so much being taken out of the system?

On top of that, the OBR fiscal risks and sustainability report released this month politely points out that due to a combination of health, social care, pension and defence spending, government day-to-day spending is projected to rise from 40% of GDP in 2030/2031 to 49% in 2075/2076.² The OBR points out that taxation will represent 47% of GDP at that point too, and that the debt-to-GDP ratio will reach 300%.

Long before any of those figures will be reached, it seems plausible that a UK debt crisis could unfold, similar to what we saw in the 1970s. The United Kingdom is not alone in this; most of Europe is facing a similar crisis, and for some countries, it will come sooner.

So why would one want to become prime minister when the outlook is so bleak? The room for manoeuvring is so limited. You would only do so if you thought you could transform growth and productivity, to avoid the calamity the long-term forecasts auger.

The Starmer government raised its spending and relied on increases in taxation to achieve the “Fiscal Rules.” The tax rises have affected both incomes and employers through changes to National Insurance contributions. Has this harmed growth?

The modern academic literature is remarkably consistent on one point: Tax increases tend to reduce economic activity. Research by Davide Furceri and Georgios Karras found that increases in the tax share of GDP were associated with lower long-run output across OECD economies.³

Meanwhile, Christina and David Romer's influential work suggested that exogenous tax increases could have even larger effects on GDP than previously believed.⁴ Later studies by Karel Mertens and Morten Ravn reinforced the conclusion that taxation can have significant negative effects on investment, employment and output.⁵

Jens Arnold and other researchers at the OECD explored which taxes hurt the most. Their conclusion, which is now an economic consensus, is that the most damaging taxes to growth are corporate taxation, followed by personal income tax.⁶ Consumption taxes are relatively less harmful, while recurring property taxes have had the smallest negative impact on economic outcomes.

Viewed through Arnold’s work, it’s hard to imagine a more damaging set of tax rises than those enacted by Starmer and Reeves. Fiscal drag from frozen income tax levels and high labour taxation for companies. You must wonder who advised doing something like this?

But this tax issue is only one side of the coin.

The difficulty with applying textbook tax multipliers to the United Kingdom is that Britain is not simply raising taxes and withdrawing demand from the economy. The proceeds are being used to finance a larger state. So, what is the state doing with these taxes?

A pound raised in tax to finance higher consumption has a very different effect from a pound invested in infrastructure, housing, skills or research. Studies by Alberto Alesina et al. consistently highlighted that the design of fiscal policy matters as much as its size.⁷

Higher taxes almost certainly mean weaker growth than would otherwise have occurred. The most immediate effects are likely to be felt through household disposable incomes, labour costs and business investment decisions. Fiscal drag, Starmer and Reeves’ principal tax-raising measure, steadily removes spending power from households without the political visibility of overt tax increases. In the United Kingdom, these tax rises mean that real disposable income is not expected to grow more than 0.2% a year to 2031.

For investors, this suggests that the biggest burden may fall not on the wider economy but on sectors most exposed to domestic consumption. Retailers, leisure operators, consumer discretionary businesses and other labour-intensive service sectors face the greatest risk from a prolonged squeeze on household finances—which is a good summary of market underperformers over the last two years.

If these tax revenues are largely absorbed by pension spending, welfare transfers and day-to-day public consumption, the growth benefits will likely be limited. Such expenditure may serve important social objectives, but it does little to improve the economy's productive capacity. In this scenario, the negative will far outweigh the positive.

However, if additional taxes were directed towards electricity networks, transport projects, housing supply, defence technology, vocational skills and productivity-enhancing infrastructure, the picture changes substantially. Higher taxes will still be negative in the short term, but over time, a stronger and more productive economy could offset a large proportion of the costs.

History suggests that countries can sustain relatively high tax burdens when revenues are allocated efficiently. Equally, low-tax economies can underperform if they fail to invest adequately in their future productive capacity.

So, a series of tough political choices face Andy Burnham and any subsequent prime minister. Raising taxes to invest would negate the initial negative impact on the economy. In fact, if that investment crowds in private sector investment as well, it could soon be seen as a benefit. Borrowing for investment could have a significantly higher benefit, if the markets are prepared to lend for that.

There is the problem. Would the markets support such a programme when a nation’s debt-to-GDP is already 100%? It’s easy to see why the Truss approach of a £40 billion increase in spending to fund tax cuts and not investments was never going to work. To persuade the markets, leaders will need to show they are serious about a primary budget surplus and are prepared to reduce spending, if necessary, in areas that have a low or no multiplier. Starmer and Reeves fell at this hurdle. It will take skill and political courage to produce a budget that the market and the backbenches can accept, and that grows the economy. I think (hope) it is doable, but it is a very high and narrow path to walk on.

Welcome to the Labour Government V2.0.