The new government has tried to set the bar as low as possible ahead of Rachel Reeves’ first Budget on 30 October.
There is a good deal of political expectations management going on. The chancellor faces a significant challenge, juggling the need to support economic growth, respect her party’s manifesto commitments and ensure the health of the public finances.
There is an opportunity for a much-needed reset, backed by a government with a large majority. It’s a chance to set out a clear agenda to revive investment – the weakness of which lies behind the UK economy’s long funk – and to learn lessons from some of her predecessors’ wrong turns. Whether the chancellor will grasp this opportunity remains to be seen.
Why the need to focus on investment? UK investment in the public and private sectors has been unusually weak compared with developed market peers for some time. That weakness has been a huge contributor to the chronic poor performance of the UK economy. The legacy of cuts to public investment in the 2010s has been creaking public services and a clear toll on growth.
In the private sector, business investment as a share of the economy has consistently been lower in the UK than the rest of the G7 group of major economies for decades, again hurting growth.
Reeves is well aware of the problem and has highlighted the issue herself many times. But recognising the issue is one thing; doing something about it is another. There are a number of key steps we’d like to see.
First: avoid the pitfall of the 2010s austerity period and ensure public sector investment is preserved.
The experience of the 2010s demonstrates that curtailing investment like this would be self-defeating. The short-term savings from cutting public investment in that period proved illusory. The associated long-term damage to growth ultimately made the public finances less, not more, sustainable.
Public services are starting from a weaker position now. More investment is needed, not less. The symbolism of Reeves’ August announcement scrapping some road and rail investment schemes was concerning.
Second: avoid counterproductive tax changes – specifically those that might discourage private investment.
Increasing public investment spending will inevitably raise questions about how the change is financed. In its manifesto, Labour ruled out changes to the four taxes that raise most revenue: income tax, national insurance, VAT and corporation tax. That’s why capital gains tax (CGT) and inheritance tax (IHT) have been in the spotlight, but there is clear danger in making sweeping changes to taxes on assets.
In most advanced economies, capital gains are taxed at a lower rate than labour income (with the UK’s rate close to the average). Capital is far more flexible than labour and people can control when they crystallise capital gains, and to some extent where they accumulate and sell assets. As a result, when rates increase, taxpayer behaviour can adjust in ways that shrink the tax base.
This means large increases in CGT rates may bring in disappointingly little revenue from the government’s perspective. HMRC analysis suggests that large increases in CGT rates may even cause receipts to fall for precisely this reason.
There’s also empirical evidence that higher CGT rates can discourage entrepreneurship and investment in small firms. Pushing too hard in this area therefore risks both failing to help the public finances and working against broader efforts to support investment.
A better alternative would be to find flexibility in the fiscal rules to support investment with some extra borrowing. That does not mean abandoning independent scrutiny of the public finances à la Liz Truss. Reeves is right to emphasise the oversight of the Office for Budgetary Responsibility, which former prime minister Truss and her chancellor Kwasi Kwarteng cast by the wayside.
But the shadow of the Truss ‘mini budget’ debacle shouldn’t cause the existing rules to become a straitjacket either. It’s widely acknowledged that the current debt rule creates a perverse incentive to cut investment over current spending, regardless of the long-term value that investment may create. In that context, tweaking the rule to facilitate more investment would be a good thing and not likely to upset the government bond market.
Third: support a broader pro-investment agenda. Given the entrenched weakness of investment in the UK, what’s required is a holistic programme of change which addresses the current roadblocks.
The UK’s sclerotic planning system, widely identified as a brake on growth, is a good place to start. Now’s the time to deliver reform, to allow housebuilding to increase and to reduce the time and cost associated with constructing new infrastructure – an area where the UK currently scores poorly relative to peers.
Similarly, the pensions system could do more to support investment in productive assets. Consolidation of pension schemes and incentives to invest more in productive UK assets would help. Legal changes have far more chance of success than moral suasion.
Otherwise, Labour’s manifesto commitments to retain the ‘full expensing’ of some investment and the annual investment allowance for small businesses are positive.
The chancellor could expand the scope of full expensing. (It currently covers plant and machinery, but not things like training and intangible assets such as software.)
She could affirm the government’s commitment to the existing tax credit for research and development and the patent box system, which provides a reduced 10% tax rate on profits from relevant patents.
Business rates reform has been promised too and a useful first step would be extending the relief for companies investing in upgrading commercial premises.
Lastly, in setting out the government’s new industrial strategy, lessons should be learned from the UK’s piecemeal, stop-start approach of the past decade-plus and the varying experiences of industrial policy around the world.
Consistency and clearly defined, measurable targets are vital. By one count, the UK has had 11 separate strategies since 2010, usually with vague economy-wide goals that are hard to track and do nothing to promote accountability.
Labour’s proposal to re-establish an Industrial Strategy Council on a statutory basis that will report to Parliament is a good idea, but several of its ‘missions’ are ill-defined.
Meanwhile, global experience suggests a decentralised, bottom-up approach has a greater chance of success than the top-down ‘picking winners’ model usually pursued in the UK. Working in partnership with the private sector and with local/ regional governments should help to ensure both faster delivery and that investment happens where it is needed most.
Oliver Jones is head of asset allocation at Rathbones. The views expressed above should not be taken as investment advice.