Merlin Weekly Macro: Can Reeves’s budget change Labour’s fortunes?

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Busted! Bang to rights! Again. First, she was given a humiliating formal dressing down by the Deputy Speaker for being in contempt of parliament thanks to all the pre-budget briefing and egregious kite-flying, including that bizarre emergency press conference from No 11 a couple of weeks ago. Sitting down an hour-and-a-quarter later after seemingly confidently and combatively presenting her second Budget which the Office for Budget Responsibility (OBR) had inadvertently and embarrassingly already leaked an hour before she spoke, Chancellor Rachel Reeves’ subsequent body language said it all. While not as fired up with the vim and vigour of Rishi Sunak last year, his successor Kemi Badenoch as Leader of the Opposition was soon landing the punches and had Reeves on the ropes. Reeves knew it. So did Keir Starmer. And just like last year, she sank back into the green front bench under withering fire and was soon wearing that hunted, rabbit-in-the-headlight look she cannot hide when under intense pressure.

Tax……

Having raised £40 billion last October and declared the country’s finances “fixed”, and having explicitly promised not to “go back to the tax well next year”, she has sunk her rusty, leaky bucket deep down it again for a second draw. This time, she has announced plans to raise another £26 billion by 2029/30 from taxation, £30 billion from all revenue-raising measures. She hopes that this will raise her fiscal headroom (i.e. the contingency for when future sums don’t add up and she would otherwise have to resort to borrowings in breach of her fiscal rules) from £9 billion to £22 billion.

Labour has new deputy leader Lucy Powell to thank that the rates of income tax, VAT and NI remained unchanged: she had vociferously and effectively led the charge that if Labour broke that explicit promise, it could kiss goodbye to being re-elected in 2029. Instead, and despite also saying a year ago that this would not be repeated, Reeves plumbed again for the tried and tested sleight of hand practised by all Chancellors: freezing the income tax bands. This time she extended the period out to 2031 from 2028. That “fiscal drag”, which sees more paying tax for the first time, and current income taxpayers dragged into higher marginal brackets, will raise around £8 billion. A new wheeze was to remove the bulk of the NI shelter (there will be a £2,000 a year cap) for both employers and employees for salary sacrifice schemes relating to pension contributions, raising a further £4.7 billion.

To say that the “rate of taxation” has not been changed is technically true for “earned” income; but it is a semantic smokescreen and a fiscal artifice: if by freezing the bands your marginal employed income is taxed at a higher rate, your personal rate of tax has been raised by the government. Cynically, the Chancellor hopes that the working public a) does not notice and b) will have forgotten about the chicanery by the time of the election. For those with “unearned” income sources (e.g. rents, dividends etc), she raised the nominal taxation rates by two percentage points, raising a further £2.1 billion in the first year. Taking all these measures together, they are a very odd way of getting people to work harder and to save or invest more.

As for capital, the direct assault on assets was much as trailed: it comes in the form of a new £2,500 “High Value Homes Surcharge”, an additional annual tax which will be levied by the central Treasury for houses worth in excess of £2 million, and £7,500 for houses valued at more than £5 million (in both cases seemingly based on Council Tax bands, rather than market value, so sure to prompt intense discussions and disputes for those whose homes are on the margin, where the market value of an individual property might be below the threshold, but the authorities determine the average price for that band is above). If the initial revenue is modest at £400 million, nevertheless a precedent has been set for direct taxation on the ownership of assets. Both the thresholds and the levies can be easily changed in future. As it is, the base-line charges are index-linked and will be reassessed every five years. To mix metaphors, it is a slippery slope and a wedge in the door.

So much for government tax income which is projected to reach an all-time high of 38.3% of GDP in 2030/31 up from 34.7% today (i.e. the “tax burden”).

….and spend

Reeves will have met nobody on her side of the House shedding any tears over tax policy and “soaking the rich”, to use the popular jargon (she got in a jibe to a complaining Tory opposite along the lines of “if you’ve got a £5 million house you can afford seven-and-a-half grand tax on it”). The biggest cheer of the day from the home benches was reserved for the abolition of the two-child benefit cap at a cost of £3.1 billion; only twelve months ago, Reeves had declared this to be unaffordable; her own capitulation to the far-Left to save her political skin is complete. The total effect of Starmer’s cave-in over disability benefit reform and the reversal of the winter fuel allowance cuts announced last year, plus this cap-lifting and others all add up to the welfare bill rising from £315 billion in 2024/25 to £389.4 billion in 2029/30. That latter figure is £16 billion greater than was forecast only six months ago. The OBR estimates that the cumulative additional cost of those welfare policy changes announced this week compared with March amounts to £60 billion over five years; that total welfare bill will be the equivalent of 11.2% of GDP compared with 10.9% now. The transfer of revenue income from those who are economically active to those who are inactive (whether involuntarily inactive or not does not matter—Labour insists it is paid for) is simply staggering.

It goes without saying that the NHS also sees a big real-terms lift in funding.

Fiscal plumbing, social engineering or electioneering? All three!

All budgets are political. It is the nature of the beast. But this one was particularly so. It was an appeal to Labour’s core constituency. With the surge in support for Reform and Labour’s collapse in the polls since the election, this is a government already fighting for survival at the 2029 election. It is headed by a Prime Minister and Chancellor who are both on notice that they will be jettisoned if Labour’s fortunes do not shape up very quickly. A confident Chancellor with a 148-seat majority behind her would not have spent much of her speech on the defensive, blaming the Tories for the actions she has taken; inevitably she took a pop at Reform (accusing Nigel Farage of being a “Russian asset”, an accusation which seemed to pass the Deputy Speaker by); and seeing the alarming surge in the hard-left Green vote, she cheerfully poured scorn on leader Zac Polansky’s lack of understanding of basic economics.

Within England, her policy emphasis was on pushing investment to the regions, the Red Wall seats in which Labour could be wiped out by Reform. In the devolved nations, the £1.7 billion allocated in aggregate to Scotland, Wales and Northern Ireland was nothing less than a political bung to shore up Labour’s prospects and to quell the nationalist upsurges.

In all, it was an unapologetically redistributive, tax-and-spend, socialist budget with more than a hint of fiscal gerrymandering.

Business: it’s not just about the Budget

The business sector breathed a sigh of relief that Reeves had not done much more damage than that inflicted a year ago. But while all the focus here has been on fiscal policy, business knows that more pain is yet to come thanks to the Employment Rights Bill launched by Angela Rayner; that Bill is completing its parliamentary passage and will load significant cost and compliance burdens on the private sector with all its knock-on effects on competitiveness, productivity and employment.

Structural reform and economic repair? Forget it

What this budget has not done is to address any of the UK’s structural economic and financial problems. As we wrote on 7 November about imbalances, “We are developing an over-reliance on the public sector particularly for marginal employment; we have too many people of working age who are economically inactive and too many who depend on benefits for their income; the private sector is heavily over-reliant on services and is under-invested and under-represented in manufacturing from both of which flows a constant current account deficit and an imbalance between imports and exports; we have a gross imbalance in the taxation system under which the over-reliance on a very small proportion of asset-rich and well-paid people to pay a disproportionate percentage of income and capital taxes is a structural weakness and a threat to sustainability. Labour clearly has no intention of effecting fundamental repair. That challenge is for whichever government comes next.”

There was absolutely nothing in the 2025 Budget which causes us to alter any part of that assessment. If anything, the imbalance between the public and private sectors has just got worse. Despite the fiscal drag, the tax changes have done little to address the narrowness of the high-yielding tax-base and the vulnerability from the risk that the super-wealthy flee these shores as so many have already done in the last year, many ending up in Italy where Georgia Meloni has been welcoming them, their capital and their spending power with open arms.

Reeves quite rightly identified the UK’s chronic productivity gap as a blight on growth; Richard Hughes, head of the OBR, said on Radio 4 later that none of the policy changes announced in the Budget has “any material effect on the outlook for either growth or productivity”. What an indictment.

Investment Perspective

Against this overwhelmingly pedestrian and underwhelming macro-economic outlook, it may seem perverse that investors are optimistic. They take their cue from the outlook for interest rates. The OBR has raised its current year estimates for growth but lowered its average real GDP forecast out to 2030/31 from 1.8% to 1.5%. Its assessment for average inflation is lower too. Fixed income investors see this as justification to pressure the Bank of England to continue lowering interest rates: as bond yields fall, prices rise. Equity investors see falling interest rates as stimulatory, helping the demand-side of the economy and reducing corporate borrowing costs.

What if…?

Investors regard themselves as pragmatists: they deal with what they think they know is in front of them, they make assumptions about variability (i.e. risk assessment) and discount all those factors back to a present-day value to identify “mispriced” assets. That is what they have done with the Budget news.

But let us consider that risk in the context of UK politics and the 2029 election, recognising that much can change between now and then. British politics is splintering both to the right and the left; the old two-plus-one system that has dominated the political scene for a century is fast breaking down. The momentum today is with a politically mongrel Reform Party and the Marxist Greens at the expense of the traditional Labour, Conservative and LibDem stalwarts. But the polls indicate that while Reform has built a commanding lead, to the right of the centre-line it and the Tories only account for 45% of the votes; 55% still intend to vote for parties to the left of centre.

We have a first past the post electoral system which makes predicting election outcomes a hit-and-miss affair. While the received wisdom is that it will be a Reform or Reform-led government which emerges from the 2029 election, it is well within the bounds of reality for a left-of-centre coalition to emerge in which the influence of the far-Left could be instrumental in shaping social and fiscal policy (it happened in Scotland with the advent of the SNP/Green alliance).

If the bond markets have been appeased by Reeves and her adherence to the fiscal rules (despite already sky-high nominal debt still rising), a potential government in the grip of Marxist Modern Monetary Theory (or the “Magic Money Tree”) is not inconceivable. Reeves was right to call out Green Party leader Zac Polansky’s lack of understanding about the interrelationship between the Bank of England and the Treasury and who “owns” the government’s debt. More pernicious is the possibility that it is not that he, his followers and others on the far-Left don’t understand about how government borrowings work and how capital is raised, it is that they simply don’t care. Their credo is the socialisation of that debt, unfettered social spending and the extreme redistribution of wealth. GDP, economic growth, productivity, competitiveness etc are not their barometers of progress.

The electorate is fickle. That we could end up with such a government is a possibility. Investors would have to make rapid re-calculations. Hold that thought.

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