Can Reeves increase investment and avoid austerity?

There are two levers or seesaws that will determine the success or failure of Rachel Reeves’s momentous budget on October 30 - a budget that will determine whether this government moves to calmer waters from the current buffeting.

They are a debt/interest seesaw and a tax/private-sector-investment lever.

And what these seesaws make incredibly difficult for Reeves is to achieve she and Starmer’s twin stated ambitions which are to increase productive investment while avoiding public-service austerity.

Here is why.

The first lever balances increased public-sector investment financed by additional borrowing against the increase in interest payments that will be loaded on taxpayers from this increment to public sector debt.

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Rachel Reeves’s decision to change one of her fiscal rules from a target to reduce gross debt as a share of GDP in five years time to one of growing net worth (debt minus the value of created assets) is still murky in the detail. But the principle is clear: it will allow her to borrow tens of billions of pounds more for productive investment in the lifetime of this government.

However, the amount she can sensibly borrow is constrained by her other fiscal rule, namely to finance all day-to-day public spending - on public sector wages, welfare payments and so on - with taxation by some future date that has not yet been specified (and will be in the budget). In other words, she will not borrow to pay the government’s running costs.

You will immediately grasp, therefore, that if she borrows colossal sums for investment, the interest that the government would shell out on the increased debt would limit the amount of cash available to pay for pensions, social security and nurses wages, inter alia.

Or at least that would be the limiting condition in the coming few years.

Thereafter the investments she has financed - in green energy, and transport, and housing - should increase the nation’s productivity and growth, which in turn would boost tax revenues.

But in the words of a recent Office for Budget Responsibility report, "a sustained 1 per cent of GDP increase in public investment could plausibly increase the level of potential output by just under ½ a percent after five years and around 2½ per cent in the long run (50 years)”.

Such an investment-fueled increase in GDP is not to be sniffed at. But it does not remotely make the increase in government capital spending self-financing before the next general election.

Or to put it another way, if this government wants to achieve its twin ambitions of increasing investment and avoiding austerity in public services, taxes have to go up, quite significantly - perhaps by as much as an eye-watering £25bn per annum, according to the Institute of Fiscal Studies.

Which takes us to the second lever, between the benefits of increasing taxes and the disbenefits of consequentially discouraging private-sector investment.

There are two substantial tax changes Reeves is considering, and they both have significant implications for private-sector businesses.

One is to make employers’ pension contributions liable to national insurance. And the other is to raise the rates of capital gains tax.

When it comes to CGT increases, one limiting factor is simply that owners would hang onto their assets longer to avoid crystallizing a liability or would move abroad to avoid it altogether if the tax rate were increased very significantly.

But for both taxes the more important limiting factor is the way they would increase business costs, dampen animal spirits and economic activity, and therefore reduce private-sector investment, at a time when our entire future prosperity as a nation hinges on whether the government can end decades of relative under-investment in the UK.

So here is the nutshell of Reeves’s quandary: if she borrows too much to finance desperately needed investment in crumbling infrastructure, the inevitable interest bill adds to the pressure on her to put up taxes, which then discourages equally vital private-sector investment.

It is a nightmare for her.

And the tragedy for this government is that it was partly avoidable. The dilemma would have been less acute if she hadn’t tied her hands during the general election campaign by promising not to raise the rates of income tax, corporation tax and VAT.

So much of what has so far gone wrong for Starmer and Reeves is that they didn’t think enough about the implications for their ability to govern of what they thought they needed to promise voters in order to get into government.

Unlike Blair and Brown in 1997, they did too little detailed preparation for the heavy burdens of being in office.

Reeves may find a happy compromise that somehow reconciles short-term public service rehabilitation with long-term growth. But my goodness it will be hard.

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