Rachel Reeves is about to get a harsh lesson in one of the most basic rules of economics

There is a limit to how high taxes can go in an open society; and we may soon reach it. 

The Chancellor, Rachel Reeves, plans to enlarge the revenue-consuming part of the economy at the expense of the revenue-generating part. Having repeatedly assured us that there would be no tax rises beyond the three anticipated in the Labour manifesto – VAT on school fees, a levy on energy companies and no more exemptions for non-doms – she is preparing to U-turn.

Her spinners, unafraid of cliché, tell us that they have opened the books and found a worse situation than they had expected. The Tories have “presided over a black hole” to the tune of £19 billion, a Labour source told Friday’s newspaper. 
Before we come to why we can’t raise taxes further without damaging growth and reducing revenue, it is worth taking a moment to consider the silliness of what Labour is claiming.

First, there are no “books”, no password-protected numbers stored away in the recesses of the Treasury. For 14 years, fiscal policy has been subject to public and independent oversight by the Office for Budget Responsibility (OBR). The “books”, if you insist, are as open to you or me as they are to ministers. 

Reeves, in other words, knew perfectly well what the situation was when she said that every Labour policy was “fully funded and fully costed – no ifs, no ands, no buts”. She understood what pressures there were on the public finances when, during the general election, she repeatedly promised “no additional tax rises” beyond the three that Labour had admitted to.

Second, far from deteriorating, the economic outlook has improved since Labour drew up its plans. Everyone says so. Even the IMF, which has been wrongly predicting recessions ever since the Brexit vote, has upped its forecasts. Britain’s PMI, a measure of business confidence, has been more positive than the eurozone’s for months. So far this year, ours has been the most successful of the world’s major economies.

Third, the claim that Labour is inheriting a uniquely poor situation is palpable piffle. We don’t have to reach back to Wilson’s devaluation or Healey’s IMF bailout. We need only recall the situation that the last Labour government bequeathed 14 years ago. In 2010, unemployment was at 8 per cent; now it is 4.4 per cent. In 2010, inflation was at 3.4 per cent; now it’s 2 per cent, precisely on target. In 2010, the deficit was about 10 per cent of GDP and forecast to grow; now, it is 3.1 per cent and falling.

Fourth, the reason that taxes, prices, spending and borrowing rose is that we paid people to stay at home for the better part of two years – a policy that Labour wanted to prolong.

Will voters buy this “looked at the books” farrago? Maybe. There is a lot of anger at the last government, which, even before the pandemic and the Ukraine war, had pushed up public spending needlessly. Difficult decisions, such as whether to compensate the Waspi women, were deferred.

As recently as the general election campaign, the Conservatives were cretinously boasting about how much they were increasing budgets. Labour, in short, will never come closer to having the benefit of the doubt.

Which taxes might it raise? Those that could bring in a chunk of revenue – income tax, national insurance and VAT – are deeply resented. Hence Labour’s promises not to raise taxes “on working people”.

In reality, of course, all taxes are ultimately paid by working people. An oil company no more pays the windfall levy than your television set pays the licence fee or your house the council tax. When Labour says it won’t tax working people, it means it won’t tax them as workers. In other words, the coming tax rises will fall on homes, savings or inheritance.

Unfortunately, these are precisely the taxes that most impede growth. A hike in capital gains tax, for example, penalises savings, which means less investment, while at the same time clobbering the City of London. It would be less damaging to raise an equivalent sum through income tax.

In the same way, VAT on schools means fewer providers and so, over time, a less educated population. Scrapping non-dom status drives plutocrats overseas and leaves the rest of us – working people, as Reeves might put it – to pick up their share of the bill. Retrospectively taxing energy firms drives away investment, which over time means lower tax receipts.

Does there come a point at which taxes simply can’t rise further? Yes. It was the 14th-century sage Ibn Khaldun – not, as is more commonly claimed, the American economist Art Laffer – who first pointed out that pushing tax rates above a certain level reduces government revenue. 

Laffer popularised the idea, putting it in the form of a curve – a curve he drew sideways, he later admitted, to hold his students’ attention by making it look like a woman’s breast. At one end, if tax rates were zero, the tax take would obviously also be zero. At the other, if tax rates were 100 per cent, the take would also be zero, since no one would work. The challenge was to find the optimum point on the curve, the rate that yielded the highest revenue. 

Most analysts think it is somewhere around 25 per cent, though it depends on which country and which taxes. No state, even a communist dictatorship that forces people at gunpoint to work on state enterprises, has ever managed to get the rate above 70 per cent.

For a relatively open economy such as Britain, where people are free to emigrate, retire earlier or simply work shorter hours, the figure is much lower.

How much lower? “If you look at tax take as a percentage of GDP going back to the early 1960s,” says Mark Littlewood, recently head of the Institute of Economic Affairs, “it seems damned near impossible to get more than about 38 per cent of national income in tax receipts.” According to the OBR, our tax take will rise to more than 37 per cent in 2028. But our spending is 44.5 per cent, creating a significant shortfall.

If Labour cannot tax at above 38 per cent, at least not for long, it has two other options. One is to cut spending, by winding up programmes, slashing the government payroll or reducing the state pension. The other is to stimulate growth, so that taxes fall as a proportion of the economy while revenue rises in absolute terms.

This second might seem obviously preferable to a party that believes in the beneficence of state action. But it, too, involves unpopular decisions, such as ending the NHS monopoly, or making the employment market freer.

Reeves shows no inclination to take on vested interests, particularly the public-sector unions that oppose reform. The last government tried to tie public-sector pay increases to improvements in productivity, thereby prompting strikes. But the Chancellor has indicated that she will give millions of state workers a 5.5 per cent pay rise – that is, 3.5 per cent above inflation – in exchange for nothing more than a halting of strike action. That alone will cost the country several billions.

A new government with a large mandate could do things that a fag-end, post-Covid administration was too timid and exhausted to try. It could bring our healthcare system into line with those of Europe, halt the rise in mental-health sicknotes, remove burdensome eco regulations or raise the state pension age. But it shows every sign of preferring short-term popularity to long-term prosperity. 

The fault, dear Brutus, is not in our stars, but in ourselves. As a nation, we are choosing to be poorer.