Thinktank says tax increases in budget will be necessary even if Rachel Reeves changes fiscal rules

The IFS preview of the looming budget says Labour will need to raises taxes to new highs to meet its goal of ending austerity and restoring services such as public libraries. Photograph: Ruskin Photos/Alamy

Keir Starmer’s promise to end austerity and rebuild public services will require tax increases of £25bn a year in the coming budget even if debt rules are changed to provide scope for extra investment spending, a leading thinktank has said.

In its preview of the first Labour budget in 14 years, the Institute for Fiscal Studies said Rachel Reeves would need to raise taxes to fresh record levels to meet the government’s policy goals. The chancellor was also warned of the risk of a Liz Truss-style meltdown if the City responded badly to substantially higher borrowing.

The IFS said Reeves faced a challenge in finding £25bn of tax increases, given that Labour’s election manifesto ruled out raising income tax, employees’ national insurance contributions and VAT.

At prime minister’s questions yesterday, Starmer was twice pressed by the opposition leader, Rishi Sunak, to rule out an increase in employer NICs – a move that would raise more than £8bn a year – but refused to do so.

“We made an absolute commitment in relation to not raising tax on working people,” the prime minister said. Pressed again, he added: “We set out our promises in the manifesto. We were returned with a huge majority to change the country for the better, and I stick to my promises in the manifesto.”

In the run-up to the election, Labour outlined plans for £9bn of tax increases, but the IFS said that if Reeves wanted to increase spending on public services in line with national income she would need to raise a further £16bn to meet her rule that day-to-day spending should be covered by tax receipts.

“Given the pledges she has made not to raise the main rates of income tax and corporation tax, or to increase national insurance or VAT at all, she might struggle to implement a tax rise on that scale,” the thinktank said.

“It would be bigger than the net tax rises implemented in July 1997 and October 2010 (both around £13bn-£14bn). In which case she might have to live with day-to-day spending on many public services falling as a fraction of national income.”

Although incoming governments tend to load tax increases and spending cuts into the first budget after an election, the IFS said an ageing population and the loss of fuel duty and tobacco revenue as people switch to electric vehicles and stop smoking would mean further tough packages in the future. “Things could get harder over this parliament,” it said.

The Office for Budget Responsibility – the government’s tax and spending watchdog – has predicted that tax as a share of national income is on course to reach 37.1% by 2028-9 – its highest level since 1948. A further £25bn of tax increases from Reeves would push tax close to 38% of GDP.

The IFS said there would be no need for the extra £16bn of tax increases on top of Labour’s manifesto commitments if spending on public services merely increased in line with inflation, but said there was pressure on the chancellor to go further.

“Simply maintaining day-to-day spending in real terms in areas such as skills, courts and prisons might – given the pressures on public sector pay and the desire to deliver significant improvements in service quality – prove to be insufficient.”

Much of the pre-budget speculation in recent days has focused on whether Reeves will adopt a different debt rule to increase her scope for increased spending on infrastructure projects. At present, the rule stipulates that debt – excluding Bank of England operations – must be falling as share of national income within five years.

However, it has been reported that the chancellor plans to change the way in which debt is calculated to provide up to £50bn of extra spending headroom.

The IFS said that even if the fiscal rules were changed so that debt continued to rise in the final year of the forecast, Reeves would still need tax rises to avoid spending cuts and meet her pledge to borrow only to invest.

Ben Nabarro, chief UK economist at Citi – the bank responsible for the economic forecasts underpinning the IFS’s tax, spending and borrowing assumptions – said there was a risk of a “buyer’s strike”(a run on government bonds) unless Reeves made it clear any increase in investment spending would be gradual.

“There is material concern in the gilt market about an unconstrained dash for investment out there,” Nabarro said. After Truss’s disastrous mini-budget two years ago “international investors are not really giving the gilt market the benefit of the doubt”, he added.

Since the middle of last month, the interest rate – or yield – on 10-year UK gilts has increased from 3.75% to just below 4.2%.

“If the rules are changed and there is a material risk, or the possibility is entertained that Rachel Reeves could invest something like £50bn next year, then I think it’s a conceivable risk [of a buyers’ strike],” Nabarro said.

“I don’t think it’s inherent in changing the fiscal rules at all. But it does require us to put some guardrails around that fiscal headroom and making clear it’ll only be spent in part; that it’ll be increased over time, and is policed by institutions. If that is the case then I think the risk is very low.”

Nabarro said large stocks of outstanding debt and a current account deficit meant the UK faced budget constraints that many other advanced economies do not. Additional borrowing would have to be used sparingly.

Paul Johnson, the IFS director, said: “The first budget of this new administration could be the most consequential since at least 2010. The new chancellor is committed to increasing investment spending, and to funding public services. To do so, she will need to increase taxes, or borrowing, or both.

“It is easy to think that we face a short-term challenge somewhat artificially created by a particular set of arbitrary fiscal rules. That would be a mistake. Pressures on health and pension spending will continue to increase, and revenues from fuel and tobacco duties will fall.

“That will make remaining on course for current budget balance harder over the course of this parliament. If Ms Reeves does not grasp the nettle on 30 October, it could come back to sting her again before the next election.”

A Treasury spokesperson said: “It’s right to say that we have inherited a tough financial position, but we won’t let the challenges of the past define our future.

“Despite uncovering a £22bn black hole in our public finances we are focused on making this the most pro-growth Treasury in history, built on the rock of economic stability, including robust fiscal rules that were set out in the manifesto. That is how we will fix our public services and deliver on the promise of change.”