Welfare vote: ‘Three options Rachel Reeves has to plug the fiscal gap’

What remained of the welfare reform bill scraped through the Commons yesterday.

The government had been banking on significant savings to the disability benefit bill. But following stiff opposition from the backbenches, these savings have been wiped out.

The reversal on disability benefits will cost £5bn, with the partial reversal of the cut to the winter fuel payment adding almost £1bn.

And there will be pressure for increased welfare spending in the autumn, with many Labour MPs likely to push hard for the scrapping of the pernicious two child limit. The Chancellor also faces the prospect of the OBR downgrading productivity growth forecasts.

With public finances coming under growing pressure, the Chancellor has three options.

What are the options?

First, she could cut spending. This does not look viable either politically or practically.

Departmental budgets were only just agreed at last month’s spending review, with some facing real terms reductions.

Reopening settlements to seek further cuts would be challenging. And even a cursory look at our public services – from prisons full to the brim to councils at breaking point – shows that there is minimal scope for spending cuts.

Second, the Chancellor could tweak her fiscal rules. These are not set in stone, and they can be changed by the Chancellor.

READ MORE: Welfare vote: ‘Here are the failures it reveals – and three faint silver linings’

ndeed, she made some very welcome changes last year which enabled significant capital investment in the NHS, regional transport and social housing.

But again, there are political and practical barriers to changing the fiscal rules. The Chancellor has staked her reputation on not doing so, describing them as ‘non-negotiable’. And changes would not be cost free.

If the government were to lose the confidence of the markets, they would risk increased borrowing costs, putting greater pressure on public finances.

This leaves only one option – raising taxes. Again, there are constraints here. Labour’s manifesto ruled out increasing the rate of income tax, (employee) national insurance, and VAT. This limits the Chancellor’s revenue raising options, as these three taxes account for three quarters of all revenue.

A more progressive approach

But the Chancellor does have options to raise some revenue in a progressive way, consistent with Labour’s manifesto, and without a significant impact on desperately needed growth.

First, the Chancellor should reform pension tax relief.

Pension contributions are largely exempt from tax. While people do pay tax on pension income, most employees receive far more in tax relief than they will pay in tax on their pension. Tax relief on pensions was worth £66bn in 2022/23.

As the Fabian Society has argued, this is both expensive and unequal. The majority of this relief – some £35bn – goes to upper and higher rate taxpayers, who make up just one in five employees.

READ MORE: ‘So much for new Labour MPs being ultra-loyal Starmtroopers’

Creating a single flat-rate tax relief for individual and employer pension contributions, set at 25p for every £1, would save £5bn. Reducing the tax-free lump sum that people can draw down from their pension on retirement to £100k would save over £2bn.

Second, the Chancellor could freeze income tax thresholds.

While the manifesto committed not to increase the rate of income tax, it is silent on thresholds. Thresholds are usually increased in line with inflation. Freezing thresholds can raise a large amount of revenue in a process called ‘fiscal drag’. As wages increase, more people are drawn into the higher tax rates, and a greater proportion of employee earnings are above the thresholds.

‘The Chancellor faces a challenging situation’

The then Chancellor Rishi Sunak’s 2021 budget froze thresholds for four years. This will raise £25bn by 20227/28. The Resolution Foundation estimate that a further two year freeze could raise £7bn.

Third, the Chancellor should equalise tax on private health insurance with VAT.

Currently, the insurance premium tax, which is charged on health insurance and other types of insurance, is set at a rate of 12%. This is just over half the rate of VAT.

This tax relief benefits a small group of people who have private health insurance, and who tend to have significantly higher incomes.

READ MORE: Welfare reform bill: MPs on why they back the amendment – or back Kendall

Bringing the insurance premium tax on private health insurance into line with VAT would raise between £500m and £1.5bn a year, which could be invested in the NHS and social care.

There are several other options the Chancellor should consider; from bank surcharges to higher gambling levies. In the medium term, the government should also seek to shift the focus of tax away from income, and toward wealth.

This could both broaden the base of our tax system, and tackle the stark inequality in wealth.

The Chancellor faces a challenging situation in the autumn budget later this year. But she does have options.

Rather than cutting spending, the government should seek to raise revenue in a way consistent with Labour’s manifesto and our values, to fund the improvements in public services we desperately need.

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