Labour’s ‘no choice’ tax-raising Budget

What the measures mean for your finances

To govern is to choose.

And over the past year and a half the government has made a large number of consequential choices.

Other choices have been forced on the Chancellor - by the markets and by Labour backbenchers. These, too, have had consequences. And, together, they shaped the Budget that Rachel Reeves unveiled today.

Oh - BR!

One unexpected choice that the government did not control today was the timing of the publication of the Office for Budget Responsibility’s Economic and Fiscal Outlook. The early release of its report meant that the Chancellor stood up to describe a Budget that the outside world was already digesting.

It was a fitting finale to this most leaked, trailed and speculated of Budget announcements. 

The tyranny of choice

The Budget we got today was shaped in large part by the government’s pre-Budget choices:

• Perhaps most importantly, the government chose to limit its flexibility before last year’s election by ruling out rises in income tax, VAT and national insurance.
• A couple of weeks ago, it chose to stick to that manifesto promise. This despite sounding out the market on a broad-based hike in income tax - and finding it supportive.
• A year ago, the Chancellor chose to focus her tax-raising measures on business, making the economic growth the government needs harder to achieve.
• She then doubled down by choosing to create a wafer-thin fiscal buffer to ride out the growth downgrade that the Office for Budget Responsibility duly delivered today.
• Throughout, the government has made an important philosophical choice - to favour tax rises over spending cuts.

Other choices have been foisted on the government in the run-up to today’s Budget. These, too, have limited its room for manoeuvre.

Backbench MPs chose to block the Chancellor’s tentative attempts to manage down the country’s growing welfare bill, to force it to keep winter fuel payments in place and now to end the two-child benefit cap too.

Investors have chosen to demand a high yield when lending to the government, relative to other countries, constraining its ability to borrow. Taxpayers spend £100bn a year simply servicing the government’s debt.

Without the productivity and economic growth that might have freed us from this fiscal and economic bind, the choices the government and others have made ultimately left the Chancellor with few real choices.

They made today’s smorgasbord of tax-raising measures unavoidable.

Balancing the books

In order to meet the government’s main fiscal rule of balancing current spending with tax receipts, to double last year’s inadequate £10bn of headroom to a little over £20bn, and to pay for nearly £10bn of new welfare spending, Rachel Reeves has been obliged to find £26bn in higher taxes by 2031. Here are three of the main ways she has chosen to do it:

Freezing income tax thresholds

Easily the biggest contributor to filling the fiscal gap comes from a three-year extension to the existing freeze of income tax thresholds. This may not look like a tax hike, but it will raise £12.4bn in 2031 by dragging more people into higher tax bands as their salaries grow. The number of higher-rate taxpayers has already jumped by 78% since 2020. A fifth of all people now pay either higher or additional-rate tax.

Under plans announced by the previous Conservative government and maintained by Labour, the current thresholds - introduced in 2021 - would have stayed in place until 2028. Today, the Chancellor announced that they will remain unchanged until 2031. We estimate that if the higher rate threshold had risen in line with wages since 2000 it would stand at £69,000 today rather than just over £50,000. Fiscal drag has cost a higher rate taxpayer more than £8,000 a year in extra tax. In three years’ time that figure will be even higher.

The big risk for the government here is that the people most impacted are not the wealthiest, but those earning around £50,000 a year. Few of these will consider themselves rich, or fair game.

Sacrificing pensions

The second significant tax raiser in today’s Budget is aimed at people saving for their retirement. Support for pension savers is a huge expense for the government and it disproportionately favours higher earners. It is unsurprising that it should have been in the Chancellor’s sights today.

Like many of her predecessors, however, Ms Reeves has backed away from a politically risky attack on the pension perks that people understand well and value highly - tax relief on contributions and the ability to withdraw 25% of a pension pot tax-free. Instead, she has targeted a poorly understood aspect of the pension system - salary sacrifice.

This is the mechanism whereby employees can sidestep national insurance on their pension contributions, worth up to 8% on earnings below £50,270 and 2% on income above that amount. Employers also save their 15% NI charge on the amount ‘sacrificed’ by their employees in this way.

From April 2029, much later than expected, salary sacrifice will be limited to £2,000 a year of pension contributions. This is expected to save the government nearly £5bn in 2030, falling to £2.6bn in 2031. We must assume the three-year delay to the implementation of the measure recognises the considerable administrative burden that the change will impose on employers.

Salary sacrifice has long been a valuable benefit for both employers and employees. It encourages people to do the right thing by incentivising them to prioritise their financial security in retirement. At a time when it is generally accepted that people are not saving enough for retirement, the new salary sacrifice cap is a concern.

The work of the Pensions Commission which was launched in July is more important than ever. It is essential that the government creates an environment that supports long-term financial security.

For the rest of us, pensions may have become a bit less tax-efficient today, but they remain a key part of our financial plans. Not only are they an effective way to save for retirement but they can play an important role in mitigating the impact of frozen tax bands. They can also help avoid tax traps such as the effective 60% tax band that applies on earnings above £100,000 due to the tapering of the personal allowance above this threshold.

Targeting high-end property

Tapping into the large amount of money locked up in the country’s most valuable properties is perhaps the easiest measure to justify from a political standpoint. Targeting properties worth more than £2m passes the ‘broadest shoulders’ test but it also ensures this measure delivers little extra income to the government - just £435m in 2031. Implementing the new property tax through a surcharge to existing council tax is also administratively achievable, albeit with a delay. The new tax will not kick in until April 2028.

Owners of £2m properties will be charged an extra £2,500 a year, rising to £7,500 on a £5m house.

The Chancellor said she would consult on measures to allow homeowners to defer the payment until they sell their property. This potentially reduces the measure’s effectiveness in addressing the near-term fiscal challenge. It could also provide a significant disincentive for older people to move, and so potentially clogs up the housing market.

Bond market investors are rightly focused not just on how much the Chancellor’s tax measures will raise but when they will do so. All three of these big measures announced today are examples of jam tomorrow.

Cash ISAs

The measure that will come as no surprise to anyone who has paid any attention at all to pre-Budget speculation is the decision to cut the annual cash ISA contribution limit to £12,000.

Unlike the other measures, this one is not driven by a desire to balance the fiscal books but by a wish to reform the ISA landscape and drive long-term investment. It is a step towards supporting consumers to achieve better financial outcomes, encouraging them to benefit from the opportunities that investing in the stock market can deliver and fostering a culture of retail investment.

Our analysis shows that a lump sum of £10,000 would have grown by £863 if left in cash over the past 10 years. Meanwhile the same sum would have more than doubled to £22,395 if invested in an investment that tracked the FTSE 100 with income reinvested. The apparent security of cash comes at a significant cost. This will be even more the case if inflation persists above the Bank of England’s target, which seems likely.

The unexpected element in the Cash ISA reforms announced today is the carve out for savers aged over 65. Older savers can continue to put the full £20,000 allowance into a Cash ISA.

Obviously, this is partly designed to forestall anguished cries in certain quarters of the media, but it also makes policy sense. If the reform is designed to encourage some cash savers to shift their focus to stock market investment, it makes sense to target this at younger savers who have the longest to benefit from the compound growth of markets and the least need to derisk their finances.

It’s pleasing that the government has stepped back from a proposal to mandate investment in the UK as part of these reforms. International evidence clearly shows that geographical mandates do not work, and they risk adding another layer of complexity to the ISA range.

The government seems to have accepted that it is preferable to point investors towards suitable British investments, if that is what they are looking for as part of a balanced portfolio.

Bad news for unsheltered savings and investments

The one curve ball that the Chancellor sent the way of savers and investors was an across the board 2% rise in the rate of income tax paid on savings outside an ISA or pension. The same hike will also be applied to dividend income and to income from property.

The dividend tax alone will raise £1.4bn by 2031 and is another significant incentive for investors to shelter their investment in ISAs and pensions to the extent that they can use their annual allowances.

Market reaction

In addition to voters, MPs and the business community, the fourth key audience for the Chancellor today was the financial markets.

With every one percentage point shift in the cost of borrowing worth around £17bn to the government, keeping the so-called bond vigilantes on board today was a key focus.

Investors were looking for reassurance:

• That the Chancellor has rebuilt a prudent level of fiscal headroom
• That tax rises are balanced, at least in part, by spending cuts
• That any proposed tax rises and spending cuts are not delayed until close to the next election, raising the chance that they will actually happen
• That any measures announced do not stoke inflation - to make the path towards lower interest rates easier for the Bank of England
• That the government does not need to borrow much more
• And that she does not come back for a third slug of tax rises next Autumn

Above all the markets wanted a sense that the UK’s animal spirits can reawaken.

During the speech:

• The pound strengthened slightly to $1.32
• Bond yields fell sharply after the early publication of the OBR report showed a doubling in the Chancellor’s headroom, then moved back broadly to where they had started the day - 4.4% for the 10 year Gilt - before falling again modestly as investors digested the Budget measures.
• The FTSE 100 rose modestly, with an even stronger rise of about 1% for the more domestically focused FTSE 250.

All in all, the Chancellor can feel relieved about the market reaction to her tricky second Budget. She probably pleased her backbenchers too. Businesses, middle-income earners and investors might be forgiven for feeling less grateful.