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Rachel Reeves claims to have inherited the worst economic legacy of any British chancellor since the second world war, and economists say she has reason to be unhappy about the state of the national finances.
“Taxes are very high, debt is very high and spending needs to increase dramatically,” said Stephen Millard, deputy director of the National Institute of Economic and Social Research. “That’s where you can legitimately argue that the government has inherited a particularly bad legacy.”
What has the Labour Party stood for?
Labour is preparing to publish the results of a public spending audit on Monday, which is expected to reveal an unexpected gap of nearly £20 billion between annual spending and income.
The announcement will pave the way for significant tax increases as the Treasury seeks to put public debt as a percentage of GDP on a downward trajectory while continuing to invest in repairing public services.
In a speech on 8 July, Chancellor Reeves said a Treasury inquiry into spending pressures was needed because Labour had inherited “the worst situation since the Second World War” from the Conservatives.
The Conservative party argues that the situation is calmer than when David Cameron took over from Gordon Brown in 2010 in the wake of the global financial crisis.
How is the UK economy doing?
Analysts say Reeves’ legacy is looking increasingly favorable, judging by a range of key economic indicators.
Even after the harsh interest rate hikes, the unemployment rate remains at just 4.4%, about half what it was when the Conservative-Liberal Democrat coalition government came to power in 2010, and lower than when Margaret Thatcher won the election in 1979 and Sir Tony Blair came to power in 1997.
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Inflation, which peaked above 11% in 2022, is now at its 2% target, and many economists expect the Bank of England to cut interest rates as early as next week.
Real disposable income fell sharply during the high inflation period but has now moved into positive territory, boosting living standards.
“When it comes to the standard things that people focus on like unemployment and inflation, you can’t argue that the economic legacy is bad. It’s actually very good,” Millard said.
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But beneath the surface, some of the underlying drivers of the British economy are much more troubling. GDP growth has been consistently sluggish, a far cry from the rapid expansion that drove the fiscal turnaround since Blair came to power in 1997.
First-quarter GDP per capita remained below its level on the eve of the pandemic, and the country has indeed been experiencing slow productivity growth since the financial crisis, putting downward pressure on the economy’s potential.
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Why are finances particularly weak?
Growth well below pre-crisis trends, combined with high borrowing costs and interest payments on government bonds, will make it difficult for Chancellor Reeves to control government borrowing.
City UK economist Benjamin Nabarro argued that the “structural situation” is worse now than it was in 2010, despite the budget deficit then being much larger.
Total debt-to-GDP ratios were low at the time and funding costs were much lower because the Bank of England cut interest rates to near zero in 2010 and bought hundreds of billions of pounds worth of government debt.
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When Cameron took office the official interest rate was just 0.5% – it’s now 5.25%.
The Institute for Fiscal Studies’ analysis highlights that the current situation of low growth and high debt interest rates poses historically unprecedented challenges.
The IMF said this month that to stabilise Britain’s public debt, the gap between government spending and revenue, excluding interest payments, needs to be significantly improved.
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According to the IMF, inequality would need to be between 0.8 and 1.4 percentage points of GDP higher per year through 2024-25, depending on factors such as the assumed time horizon.
The fund estimates that real GDP growth would need to accelerate sharply to 2.6-2.7 percent per year through 2024-25 to stabilize finances without resorting to further tax increases or other draconian budgetary measures.
However, with the tax burden already approaching its highest level since the end of the war as a percentage of GDP, the room for significant tax increases is more limited than in the past.
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For the first time since the 1990s, a primary budget surplus will be needed to stabilise the debt, Mr Navarro said, adding that after a decade of relentless spending cuts and sluggish income growth, the room for manoeuvre, either on taxes or spending, was “increasingly limited”.
“In 2010, the UK was, financially speaking, a sturdy ship being tossed about by incredibly rough seas,” he said. “Since then, the rot has set in.”
