The Reeves Problem

Governments can't create growth but they can cause a recession.

In 2010 Liam Byrne made what was probably one of the most honest statements by any British politician ever when he left his successor as Chief Secretary to the Treasury a note saying “I’m afraid there is no money.”  At the time the national debt was around £1 trillion and the annual deficit was around £107 billion. The interest was some £47 billion.

Rachel Reeves inherited some £3 trillion of debt, a deficit of £120 billion a year and interest payments of over £100 billion. Incredibly the current former Chief Secretary to the Treasury, Laura Trott, thinks the Tories’ economic legacy is not a poison chalice. Clearly a degree in history and economics form Pembroke College Oxford doesn’t require the ability to count.

Part of me is almost sympathetic for the incoming Chancellor – she’s taking on a mess that is the legacy of decades of spendthrift governments. As the Trading Economics chart of public sector net borrowing  below shows, the last time the government was in surplus was in 1999, which was the second year to Blair’s first government which had undertaken to stick to John Major’s spending plans for its first two years.

While the banking crisis and the pandemic had an impact, the underlying problem is the groupthink of the Treasury, much of Westminster and most of the media, who believe it is possible for a government to tax its way to growth. It isn’t. Never has been. Never will be.

This gives Rachel Reeves a problem. The Labour Party doesn’t do austerity and the many interests that fund and voted for it expect more money. During their incredibly vague election campaign Labour promised not to increase the tax on working people, asserting instead that they would deliver growth. That’s hardly original – no government ever gets elected on promising recession, although of course that’s precisely what many deliver. How is this so?

Almost every private sector business and worker strives for growth pretty much all the time. Before MBAs complicated strategy the mantra was “sell more stuff.” That’s not easy, either you have to persuade existing customers to consume more themselves or you have to find more customers – which is not cheap. You also have to be able to make, store and deliver the additional stuff (which may be a service), and that requires investment. Any investor wants to make a profit and sensible investors seek opportunities with he highest return for an acceptable level of risk.

That return is, of course, post tax. This is where the UK has a problem; it taxes corporate profits (corporation tax) too highly so investors and companies seeking investment go elsewhere. Amazon isn’t headquartered in Ireland because of Guiness, blarney or a fondness for Celtic culture. It’s there because the corporation tax rate in Ireland is just 12.5%. The UK's government takes 25% of a company's profits and the doyens of Westminster and Whitehall wonder why investment is low.

It gets worse for the investor as the government also taxes dividends (paid from the already taxed company's profits) and any realised capital gain on the investee company's value. The reason people aren't investing in the UK is that they can make better returns at the same risk in other countries.

A pragmatist would realise this and adjust the tax regime. To her credit, that's what Liz Truss was attempting. A combination of a lack of communication and some extraordinary commentary from the IMF on her planned cut to the top 45% rate (almost economically insignificant in comparison to the rest of her package) ended it and her career. The UK has been stagnating (and borrowing) ever since. A socialist would decide that it's time for the government to intervene. Noticing that the UK Government  is fresh out of cash, Ms Reeves has decided to “require” UK pension funds to invest in the UK.

This is a terrible idea, as ably explained by Tim Worstall of the Adam Smith Institute. Fund managers are supposed to find the best possible returns for a given level of risk, and to spread their investments widely. The Reeves policy would reduce the number of managers and make them invest in opportunities that they would otherwise avoid.

In fact he understates the impact of this shocking move. Ms Reeves is proposing to nationalise private pensions, to the detriment of both the pension’s owner and the pension manager. If the UK and its infrastructure offered a good return on investment (net of tax) then there would be no need for coercion – fund managers (whose bonuses generally depend on investment returns) would be piling in to the UK. It doesn't so they're not.

That's not her only plan. Desperate for cash, Ms Reeves is looking at playing with death duties and removing an inheritance tax break on investments on the Alternative Investment Market (AIM). The mere threat of that will make some investors sell. Unfortunately AIM, sometimes referred to as London's junior equity market, does not always have the liquidity to quickly match sellers and buyers. Prices will therefore fall steeply and quickly. That will cause the AIM companies problems with things like bank loan covenants and security. (If the share price falls the ratio of debt to equity – “gearing” – rises. Banks don't like that).

The combination of high taxation and a government that feels it has the right to control pension fund assets is not attractive for any investor. Rather than creating an environment for the investment needed for growth Labour is creating one where capital flight is likely. This happened in the 1960s and 1970s forcing even John Lennon to abandon the UK. Taxing until the pips squeeze didn't work then and it won't work now.

It's not only the Labour Party's neo-Marxist attitude to economics that will prevent growth. The lunacy of Net Zero will continue to drive energy prices up. As doing more stuff requires more energy, making that energy rarer and more expensive will inhibit growth. Sadly that won't reduce the number of snake oil salespeople selling green policies as the solution to a natural phenomenon, but people doing real jobs will feel the pinch as their margins get squeezed. Sole traders and small businesses will shut down.

Labour's policies will increase the cost of capital and increase the cost of energy. Their reluctance to control immigration will force private sector labour rates down while their diminished tax take will make paying the lavish pay rises proposed for the public sector impossible without more borrowing. As the debt to GDP rate soars so will the interest rate paid (which is determined by the bond markets, not the Chancellor or the Bank of England). We're on course for another reality check from the IMF.

Which rather begs the question what the hell were the 9.6 million who voted Labour thinking?

---

Posts don’t write themselves and research takes time too. If you enjoyed this article please remember that Views From My Cab is a reader-supported publication and consider becoming subscriber (free or paid).

Or just buy me a coffee.