Promoting and taxing investment in the UK Budget

The UK’s Autumn budget is set to be announced on 30 October and speculations about the proposals that it will include are rife. Chancellor Rachel Reeves promises that the autumn budget will be a “budget for investment”, viewing investment as central to reversing the country’s slow growth. On the other hand, Labour’s manifesto promised lowering debt as a share of GDP within the next five years, raising the question of how the investment will be funded. Will it be done through (1) borrowing for investment or (2) raising taxes and (3) lower spending elsewhere to avoid increasing government debt? It is predicted that the Chancellor will opt for the first of these options, while altering the government’s fiscal rules to allow more flexibility for debt to rise when the borrowing is for the purpose of investment. Two thirds of panellists in the CfM’s March survey thought that taxes would need to rise in this parliament (Ilzetzki and Jain 2024) and the Treasury is floating ideas for specific taxes to raise.

Reeves said that “it is time that the Treasury moved on from just counting the costs of investments, to recognising the benefits too”. The UK’s investment rates have been 3 percentage points below the OECD average since 1990, which translates to a gap of around £35 billion a year. A project-by-project estimation of this gap sits around £1.6 trillion. The gap mainly stems from underinvestment in people, infrastructure, and technology (Haldane 2024). The Office of Budget Responsibility published an analysis on how they plan to model the supply-side benefits of public investments. The estimated effects are not large enough for those investments to be self-sustaining for many years. Many of the estimated benefits are also expected to materialise in the long term – past the five-year time horizon for public debt to decline. The OBR forecasts that a sustained 1% of GDP increase in government investment will increase potential output by 0.4% after five years and 2.4% after 50 years. The government, however, is estimated to only receive less than half of that amount in additional tax revenues (Suresh et al. 2024).

One potential way for Labour to fulfil its promise of debt falling as a share of GDP is using a different measure of debt than the one used by the previous government. The current method of measuring debt is public sector net debt excluding the Bank of England (PSND ex BoE). The Labour government may wish to change this debt measure by excluding more debt taken by publicly owned banks, such as the National Wealth Fund. It could also include assets and not only liabilities in its assessment of the government’s debt burden. It could do so by setting targets for public sector net liabilities (PSNL), which would evaluate debt net of public sector assets. The assets could in turn, include only financial assets (public sector net financial liabilities, PSNFL) or fixed assets as well (public sector net worth (PSNW). Putting aside the differences between these measures, any recognition of government assets would better account for the benefits of investments and not only their costs. Figure 1 shows how this revised view of public debt would have affected the fiscal headroom available to previous and future governments (see also the analysis in Chadha 2024).

Figure 1

Source: Office of Budget Responsibility. Public finances databank – September 2024, 2024.

However, changing fiscal targets risks making them irrelevant (Ilzetzki 2024). Furthermore, this and future governments may use the added fiscal space opportunistically, as different components of the UK government are fungible. It is also uncertain how financial markets will receive changes to the fiscal rules: some officials worry that it would spark a sell-off in the bond market which would have a negative financial impact on the Treasury (Stacey 2024). Therefore, economists have suggested that Reeves needs to be clear about the intention not to use the entire unlocked headroom and outline concrete plans to realise actual returns on the planned investments (Strauss and Fleming 2024).

The autumn budget’s investments are also expected to be partially financed via increased tax revenues. In addition, the IFS estimates that Reeves needs to raise around £25 billion in taxes to reverse public services cuts in the last budget (Ravikumar et al. 2024). However, the Labour government has pledged not to increase income taxes, VAT, corporate taxes, and national insurance contributions. The Treasury has indicated that it is considering raises to employers’ national insurance contributions. In the CfM March survey, 70% of respondents believed that cuts to national insurance contributions would have little stimulative effect on the economy within a year (Ilzetzki and Jain 2024). This would indicate that increases in contributions would also have only a small negative impact on the economy

Capital gains tax (CGT) rates are at historical lows and the government is said to be contemplating increasing taxes on capital gains to raise revenues. It is known that the Treasury has been testing a range between 33% and 39% (Ravikumar et al. 2024) – a large increase compared to the top rate on capital gains of 20% (or 24% for residential property and 28% for carried interest). Other options include taxing capital gains at ordinary income tax rates (making the rate even higher for most taxpayers) and limiting tax exemptions, such as the ceiling for private residence relief (Osborne Clarke 2024). According to IFS figures, only 350,000 people pay capital gains taxes and they contribute around £15 billion in CGT per year. Adam et al. (2024) claim the current system of capital taxation is highly distortionary and should be reformed.  But merely increasing tax rates within a flawed system would only make matters worse. Wealth managers have reported a sell-off trend before the budget indicating that raising capital gains taxation risks a flight of capital (Isaac 2024). A short-term sell-off would result in a temporary tax revenue boost, but this would be at the expense of tax revenues in the long run (Skero 2024). In general, there is strong evidence that investors are able to avoid higher tax rates through tax shifting, legal avoidance, and outright evasion (Slemrod 1995).

The budget is also expected to close the loopholes on inheritance tax (IHT). There could be a combination of removing the IHT exemption for residuary pension funds on death, introducing progressive IHT bands, lowering the threshold at which an estate comes into the IHT, reducing or capping the 100% business and agricultural relief (BR & AR) and other reliefs (Skero 2024). The government has also looked into introducing changes to pensions tax relief. Finally, there is some talk about the tightening of the non-doms scheme and taxation of private equity carried interest; however, Reeves has been advised by HM Treasury that large tax increases for the two could actually result in reduced tax revenues if they prompt investors to exit their UK investments (Parker and Fleming 2024).

The October 2024 CfM survey asked the members of its panel about proposals in the upcoming UK autumn budget. The panellists were asked whether fiscal rules should be altered to allow for greater public investment and whether capital gains taxes should be increased to raise revenues.

Question 1: Do you support changing the UK’s fiscal rules to allow for greater public investment, either by targeting net liabilities instead of debt, allowing debt to increase during a parliament if for the purpose of public investment, or by other means?

Twenty-one panel members responded to this question. The panel is almost unanimous that UK fiscal rules need greater flexibility to allow public investment to increase. With this said, nearly 20% of those supporting the change in fiscal rules believe there are better ways to encourage public investment.

Most panellists agree that declining debt as a share of GDP within five years fails to account for the long-term nature and benefits of public investment. Hence debt targets should restrict public investment. Martin Ellison (University of Oxford) expresses this view: “The commitment to see debt falling by the end of the parliament is arbitrary and flawed as it fails to account for the long gestation periods of public investment.” Łukasz Rachel (UCL) echoes this thought: “Some benefits of investment will only crystalise in the longer-term (e.g. investments in education, health). Equivalently, the true cost of investing - including the fiscal cost - will only emerge in the longer-term. The rules should aim to encourage more long-term thinking and decision making.” Similarly, Thomas Sampson (LSE) thinks that “investment decisions should be based on a cost-benefit analysis of specific investment proposals, not on the desire to meet a somewhat arbitrary debt target”.

Nevertheless, some panellists highlight a risk that making exceptions to the fiscal rule will allow governments to game the system and that exempting public investment may create perverse political incentives. Jagjit Chadha (NIESR) warns that “[t]he investments will have to be carefully appraised and preferably handled by an operationally independent body with minimal, other than remit guidance by our political masters.” Similarly, Nick Oulton (Centre for Economic Performance) agrees that fiscal rules should be redefined but underlines the need for “better regulation of capital regulation by public bodies”. He says that: “at the very least, ‘investment’ must be defined in strict accordance with the rules of national income accounting.” Martin Ellison (University of Oxford) adds that: “The OBR can have a role in policing whether borrowing is for investment purposes.”

Costas Milas (University of Liverpool) supports modifying fiscal rules but also proposes an alternative way to exempt investment. Quoting his letter to the Financial Times, he says that “Rachel Reeves could signal her government’s full commitment to investing in the country by issuing bonds linked to GDP, with a maturity of, say, 10 years since the Labour party has argued it needs a second term to ‘fix’ the economy. For this type of bonds, the GDP risk premium added to the cost of debt is likely to be extremely low if investors have faith in Reeves and her policies.”

Some panellists, although supportive, express some concerns and doubts about changing the fiscal rule in their individual responses. Andrea Ferrero (University of Oxford) highlights that while the idea makes sense in principle, the details will make the difference: “If markets perceive the change in fiscal rules as an attempt to increase discretionary spending, the negative repercussions on the cost of debt may outweigh any benefit of the new framework.” Similarly, Michael Wickens (Cardiff Business School and University of York) agrees that the current rules need to change but comments that “the concept of net wealth is unlikely to be of use as so few public investments are marketable.” He adds that: “The correct rule, which has been known for years, is to tax-finance current expenditures and debt-finance public investment.” On the other hand, Wouter den Han (LSE) opposes the idea of changing fiscal rules saying that: “For credibility it is important that rules are only changed rarely and after wide consultation and that also applies to rules that are not perfect”. Furthermore, he is doubtful that “what the government will do with the money will be that effective to deal with UK's investment and productivity problems.”

Question 2: Do you agree that an increase in capital gains tax is an effective way to raise revenues over the upcoming decade?

Twenty-one panellists answered this question. The panel is deeply ambivalent, with over 35% being uncertain whether increasing capital gains taxes are an effective way to raise revenues over the next decade. The share of uncertain members falls from over 35% to over a quarter when weighting the answers by self-assessed confidence levels. The rest of the panel is split between agreeing and disagreeing with the proposition. Their responses can be viewed in one of two ways. On one hand, close to 40% of the panel agrees that an increase in capital gains taxes is an effective way to raise revenues, while 20% disagree or strongly disagree with that statement. On the other hand, half of those agreeing (close to 20% of the panel) believe that there are more efficient or equitable alternatives to do so. Thus roughly 40% of the panel believes that there are better alternatives than raising capital gains taxes and only around 20% of the members believe that raising capital gains taxes is the best available policy.

The panellists’ individual responses show much more nuance than the headline figures. They show that respondents in all camps are torn between the very bad options that the government faces. Some panellists agree that there are better ways of raising revenues but also indicate that in the current situation raising capital gains tax might be a viable option. Martin Ellison (University of Oxford) thinks that: “The meagre rates for capital gains tax compared to tax rates on other income suggest that increasing capital gains tax would be a ‘least bad’ way of raising revenue.”

Others supporting increasing capital gains tax nevertheless express concerns. Jagjid Chadha (NIESR) comments: “I worry about taxes on capital accumulation, as they are generally shown to damage income over the long run. But to the extent that the old are richer and hold wealth and the young are poorer and are credit constrained, some increase in capital tax may be used to reduce the income tax paid by workers.” Łukasz Rachel (UCL) also expresses his doubts: “I worry that if a change to CGT applies retrospectively to past transactions then this amounts to an ex-post change of tax regime and is therefore not very fair, and doesn't do much to build trust/improve investment climate.” Moreover, Charles Bean (LSE) is concerned about the overall impact on the economy: “An increase in CGT rates can raise revenues but a critical issue here is whether such a move will impact on the confidence of international investors to invest in the UK economy. If the latter happens, the sterling currency will definitely weaken, therefore creating additional inflationary pressures.” Angus Armstrong (UCL) says that he “would be in favour of CGT on excess gains over a certain limit on primary residences, and on very high net worth individuals.”

Some panellists oppose increasing the CGT and point to the discrepancy between the desire for increased investment discussed in question one and the plan to raise capital gains taxes. Michael Wickens (Cardiff Business School and University of York) comments that: “Like profits taxes, higher CGT is a good way to deter private investment. It is also retrospective and only punishes successful investments.” Ricardo Reis (LSE) concurs, saying that “If more investment is strongly desirable (from question 1), then raising the taxes the returns on investment (from question 2) should clearly be the wrong thing to do.” Nick Oulton (Centre for Economic Performance) focuses on the practicality of raising revenues: “CGT raises comparatively little revenue currently and it is hard to see any reform changing that picture. The problem here is that Reeves has boxed herself in by ruling out raising almost all other taxes.”

Finally, some of the panellists believe that there are better alternatives to raise revenues than an increase in capital gains taxes. Angus Armstrong (UCL) believes that “there are also more efficient and equitable ways of raising revenue such as a land tax.” David Cobham (Heriot-Watt University) says: “Increase income tax! The mark of success for Labour is whether they can fight the next election on the basis of explicit plans for a more progressive tax system.” Andrea Ferrero (University of Oxford) believes that: “a change of the current capital gains tax rate should be part of a comprehensive review of the overall tax system.” Roger Farmer agrees and “would support simplifying the tax system to treat all forms of household income, including capital gains, in the same way. It is not obvious that a big increase in capital gains tax will raise more revenue.” Paul de Grauwe (LSE) believes that there are alternative ways to raise revenues from banks, on which he goes into great detail in his 2024 Vox column: “The BoE could use a tiered system of bank reserves whereby tier 1 (say half) is not remunerated and tier 2 is remunerated at the policy rate. In this example the transfer would be cut from £40 billion to £20 billion thereby creating a substantial source of budgetary revenue for the Treasury”. 

References

Adam, S, A Advani, H Miller and A Summers (2024), “Capital gains tax reform”, Institute for Fiscal Studies, 6 October.

Adam, S, I Delestre, C Emmerson, H Miller and D Sturrock (2024), “Raising revenue from reforms to pensions taxation”, Institute for Fiscal Studies, 11 September.

Chadha, J S (2024), “A Consideration of Fiscal Targetry”, Note to HM Treasury in advance of the 30 October Budget.

De Grauwe, P (2024), “The new operating procedures of the Bank of England: A bonanza for the banks”, VoxEU.org, 24 June. CEPR.

Elliott, L (2024), “Labour needs £25bn a year in tax rises to rebuild public services, warns IFS”, The Guardian, 10 October.

Emmerson, C, P Johnson, I Stockton and B Zaranko (2024), “Fiscal rules and investment in the upcoming Budget”, Institute for Fiscal Studies, 27 September.

Haldane, A (2024), “The unpleasant fiscal arithmetic holding back UK growth”, The Financial Times, 11 October.

Ilzetzki, E (2024), “The UK Macroeconomic Framework at 25”, in J Portes and A Menon (eds), The State of the UK Economy in 2024, UK in a Changing Europe.

Ilzetzki, E and S Jain (2024), “Evaluating the Spring Budget and the UK’s Fiscal Rules”, VoxEU.org, 2 July.

Isaac, A (2024), “Rachel Reeves considers raising capital gains tax to 39%”, The Guardian, 10 October.

Milas, C (2024) “Letter: How the chancellor can gauge investor confidence”, Financial Times, 25 September.

Osborne Clarke (2024), “UK Autumn Budget 2024: what tax measures can the UK expect?”, 9 October. 

Parker, G and S Fleming (2024), “Why Rachel Reeves is ‘walking a tightrope’ ahead of the Budget”, The Financial Times, 9 October.

Ravikumar, S, D Milliken  and W James (2024), “UK's Reeves is considering raising capital gains tax to 39%, Guardian says”, Reuters, 10 October.

Slemrod, J (1995), “Income Creation or Income Shifting? Behavioral Responses to the Tax Reform Act of 1986,” The American Economic Review 85(2): 175-180.

Stacey, K (2024), “Reeves to press ahead with plans to borrow billions for investment”, The Guardian, 9 October.

Strauss, D and S Fleming (2024), “Reeves must convince on growth to keep bond investors on side”, The Financial Times, 10 October.

Suresh, N, R Ghaw, R Obeng-Osei and T Wickstead (2024), “Public investment and potential output”, Discussion paper No. 5, Office for Budget Responsibility.