The financial turmoil in the wake of Donald Trump’s tariffs agenda is making it increasingly likely Chancellor Rachel Reeves will have to raise taxes in the autumn, leading economists have said.
Even though Reeves was boosted on Friday by figures revealing an unexpected 0.5 per cent rise in GDP in February, the UK’s economy has remained stubbornly sluggish. And with US tariffs of 10 per cent on British goods – rising to 25 per cent for the key industries of cars and steel – ill global trade winds are yet set to deal a blow to the Chancellor’s plans for growth.
A two-hour train journey from London to Solihull on Monday provided Reeves and Prime Minister Keir Starmer with time to discuss how to deal with the market instability caused by the White House’s tariff chaos.
Reeves sipped Earl Grey tea as the pair took stock of what had just happened. More crucially they had to think about “this is what we do next,” according to an aide who travelled with the pair to Jaguar Land Rover’s factory in the Midlands where they addressed a nervous workforce of car manufacturers.
Both the car workers and the politicians addressing them were still reeling from Donald Trump’s decision to impose a 10 per cent “preferential” tariff on the UK, plus 25 per cent on steel and cars with no prior warning. “We’ve got your back,” Reeves told a worried public.
A climbdown by Trump on Wednesday temporarily aligned most countries with Britain’s rate, excluding China, but didn’t provide a reprieve for the UK. But amid a US sovereign debt sell-off, long-term UK government bond yields jumped to their highest since 1998. Sustained increases in UK bond yields may yet wipe out the chancellor’s £10 billion fiscal leeway she rebuilt at her spring statement last month.
Doing this cost a degree of political capital – not least in angering many Labour MPs with £5bn of benefit cuts.
“The US tariff announcements are consistent with weaker growth and higher borrowing that would pretty much wipe out the headroom,” Andrew Goodwin, Chief UK Economist at Oxford Economics, told The i Paper.
“I think we’re likely to need a full rethink of fiscal policy, and the Chancellor has to decide what’s most important – the manifesto pledges on tax, the spending plans or the fiscal rules? Because I think one of the three at least has to give.”
So, what does Reeves do next? Although some Labour MPs are urging higher borrowing and a tax on the ultra-rich, the consensus among economists is that Reeves will resort to broader taxation to close the anticipated budget gap. The question now centres on which taxes are in her sights.
Economists say that while the Chancellor has raised employer National Insurance Contributions (NICs) by 1.2 percentage points to 15 per cent, she hasn’t reversed NICs cuts to employees introduced by the previous Conservative government.
“I think the big mistake in the autumn was not reversing the employee National Insurance Contribution cuts that happened under the previous government,” Godwin added. “
Having spent so long time talking about the black hole (the £22bn hole in the nation’s finances Reeves claims she inherited from the Conservatives), the obvious thing to do was say: ‘We could never afford these NICs cuts in the first place, we now need to reverse them’.
“That story is a little bit harder to tell now, having not taken the opportunity to reverse them, but that’s probably still the easiest option. Easy is a relative term here; it’s the less difficult one.”
There are no easy options
Modupe Adegbembo, an economist at Jeffries in London agrees taxes are on the table. “The tax lever probably offers her a bit more in terms of the kind of number gain that will be required,” she told The i Paper.
Adegbembo suggested Reeves’ tax options include relying on fiscal drag to raise revenue by not adjusting thresholds on income tax for inflation. She could also raise capital gains tax on the profit from selling an asset. NICs from employees is something she could examine again, she added.
However, raising employee NICs would be politically risky for Reeves, given her emphasis on protecting working-age voters and the significant public opposition to the employer NIC increase.
There are no easy options. While indirect taxes such as a hike on capital gains may be easier to sell politically, Reeves already put the rates up last autumn. Meanwhile, although Labour backbenchers might be satisfied by a wealth tax this too carries a risk of capital flight.
While the fiscal watchdog, the Office for Budget Responsibility (OBR), might give wealth taxes a high score for potential revenue, the rich can relocate.
“What you actually see in reality tends to be a lot lower because people make different choices,” Adegbembo said.
This week a report found London has fallen out of the top five wealthiest cities in the world after losing a higher proportion of millionaires than anywhere other than Moscow after the ultra-wealthy left the capital following Brexit, the falling value of the pound and more recently the abolition of the non-domiciled tax regime.
In Whitehall officials are more concerned with the here and now, rather than the budget in the autumn: growth is still the central plank of Reeves’ economic plan. “No one credible can say what will happen later this year,” a Treasury source told The i Paper.
As if to emphasise the point, the Chancellor’s week, so stressful at the start, ended with some rare good news. The economy grew much faster than expected in February, according to the Office for National Statistics.
When it comes to tax rises, the Treasury is staying tight-lipped. “We’re not going to write four budgets now. No one would do that. No one expects us to do that. The focus right now is got to be getting the deals, supporting the economy and going further and faster,” a spokesperson said.
Reeves can instead focus on persuading the Chair of the OBR Richard Hughes to give her future supply-side reforms – designed to boost the supply of goods and services – a high score for growth and show how they will swell the economy.
Caption: UK monthly economic growth (GDP). Infographic PA Graphics.The Treasury and OBR worked closely together in advance of the spring statement last month to score the National Planning Framework for Homes, which gave a welcome boost to Reeves’ forecasts.
According to Simon French, Chief Economist at Panmure Liberum, convincing the OBR of the merit of her plans is key in the run-up to the autumn Budget.
“You can credibly get the OBR back in the room and go, ‘Hang on, we convinced you with this weight of evidence back in February, March. Why aren’t you convinced now when we’ve effectively played the same script back to you, but in a different policy area?’,” French told The i Paper.
Insiders believe the Planning and Infrastructure Bill’s remaining measures, encompassing 150 major economic infrastructure project decisions, could significantly improve the future growth scorecard.
At the Treasury, this work is being turbocharged. “There is other supply side stuff we’re doing that we think equally should be considered and scored. So, we’ve got the space now – if we really throw everything we can in the time we’ve got – on the growth stuff now, that makes the conversations with the OBR much the better to have,” a Treasury source said.
Although Trump’s climbdown sparked a mid-week stock market surge, fuelled by optimism about a less severe global economic downturn, the UK’s competitive edge inevitably eroded this week. The unpredictable policies will continue to hinder British businesses’ planning and investment.
Fiscal rules or creative accounting?
On Wednesday, Reeves said she did not consider the economic shock so far to be sufficient to allow her to play her get-out-of-jail-free card and break her fiscal rules. Those rules allow the government to borrow to invest but obliges her to balance day-to-day spending against tax receipts.
The Chancellor is under continued pressure from Labour MPs who have been urging her to borrow more to fund an increase in defence spending and soften the blow to welfare cuts. Despite her insistence any break with the rules is not happening, some economists suspect that could change.
According to Kyle Chapman, FX Markets Analyst at Ballinger, if Reeves finds her headroom wiped out come the autumn, “she would need to loosen the fiscal rules or maybe do some creative accounting”.
Reeves might be able to explain higher borrowing with new messaging. She could use “An outright: ‘this is a different world now’,” he told The i Paper.
If she starts early enough and communicates her intentions to borrow more, even foreign bond vigilantes could be encouraged to be more forgiving and not push UK borrowing costs up.
“If you get a communication right that tends to go a long way,” Chapman said. Nevertheless, he still believes tax rises are a more likely outcome.
“The risk that we get the worst-case scenario has obviously diminished, though I still believe in tax rises being a likely outcome in October because gilt yields are still sky-high and growth risks are still to the downside,” he added.
When not instructing her officials to focus on growth, Reeves is heavily involved in discussions led by Business Secretary Jonathan Reynolds in negotiating a trade deal with the US.
Expectations are now fading that the UK can persuade Trump to reduce the 10 per cent tariffs, even as negotiators weigh up whether to allow the president wins by reducing tariffs on US agriculture and abolishing the digital services tax affecting US firms.
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Read MoreDrinking tea – Earl Grey in Reeves’s case- while keeping calm and carrying on is a particularly British approach to the chaos coming from Washington. But what more can she do as the chaos will likely carry on?
“It is a bad idea with Trump to assume that the uncertainty is ever resolved,” Chapman said. “We still have 10 per cent blanket tariffs, and the markets are watching a big game of chicken between the US and China. That is the epicentre now and it will have far-reaching impacts.”
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