An income tax raid was unthinkable. Now it looks inevitable

Rachel Reeves, the Chancellor, pictured going for a run on Wednesday, has few options to restore confidence in her economic management - Jeremy Selwyn

Rachel Reeves is under growing pressure to break one of her most high-profile promises: not to increase income tax.

Faced with a struggling economy, painfully high borrowing costs and disappointing tax receipts, the Chancellor needs to find tens of billions of pounds to get her financial plans back on track.

There is no easy, painless and popular way to do this. Reeves’s first Budget, last October, featured record tax rises that shattered business confidence and undermined Labour’s claims to be the party of growth.

You may think that would be enough to put the Chancellor off further tax rises and push her towards spending cuts instead.

Yet when the Government tried to modestly restrain growth in the benefits bill, a fierce backbench rebellion forced an about-turn.

Borrowing more was once considered the easy option. But with debt approaching £3tn and financial markets punishing further profligacy, that is off the table too.

Facing only bad options, the Chancellor has worsened her own predicament by weaving a web of overlapping promises that further limit her room for manoeuvre.

Reeves rewrote the fiscal rules last year to allow more borrowing, then immediately used up that headroom. She has subsequently called the rules “iron clad”, vowing not to ramp up borrowing further.

The Chancellor limited her capacity to restrain expenditure by setting out departmental and investment budgets for years to come in the spending review.

She has also promised to “do everything in our powers to keep costs down” in the battle against inflation and committed to the Prime Minister’s “defining mission” of economic growth – vows that, on the face of things, restrict her ability to raise many taxes at all.

Perhaps most famously, Labour’s manifesto promised not to increase income tax, National Insurance, VAT or corporation tax.

Yet it is increasingly hard to see how she can stick to every one of those promises. Facing a hole in the finances which economists estimate at anywhere between £20bn and £50bn, the Chancellor will struggle to raise enough cash through a wide range of smaller tax rises.

Only four taxes raise more than £100bn per year for the Treasury. Those are corporation tax, which is set to break above that threshold next year, VAT at more than £180bn, National Insurance, which brings in more than £200bn, and income tax, totalling almost £300bn.

By contrast even high-profile taxes such as inheritance tax raise less than £10bn per year.

Making big changes to smaller taxes can have dramatic effects on the behaviour of businesses and households, affecting the yield.

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Stamp duty revenues spiked in the spring and plunged in the summer as a tax break came to an end. The amount of alcohol duty paid so far this year is down on last year, following a rise in the tax.

Capital gains tax rises are considered easily avoidable if owners simply refuse to sell their assets, thus triggering no charge at all.

As a result, pressure is mounting on the Chancellor to ditch the manifesto pledges outright and raise income tax.

“If they politically cannot deliver spending cuts, it has got to be income tax increases,” says Anna Leach, the Institute of Directors’ chief economist.

She suggests 1p on the main and higher rates of income tax, plus a further two-year freeze on thresholds could together raise around £18bn per year, making serious steps towards filling the Chancellor’s black hole.

“If she is going to have to find £50bn, you simply cannot do that in a growth-friendly way without bringing in the big taxes,” says Leach.

Her comments follow similar calls from the Confederation of British Industry, the Resolution Foundation and the Institute for Government.

Economists see income tax as a relatively sensible levy to use, given the dire situation the Chancellor finds herself in.

“The big problem the Government has is that it needs to raise quite a large sum of money, and if it continues to rule out most of the main taxes, it means they have to hit the small taxes very hard to raise enough,” says Andrew Goodwin at Oxford Economics.

“It would be easier arithmetically to hit one of the biggest taxes by less, and it spreads the pain much more evenly across the country.”

He warns that when the Government has tried to raise money from a range of smaller taxes, it has often found revenues ultimately undershoot forecasts, leaving the Chancellor short of cash come the subsequent Budget.

Paul Dales, at Capital Economics, said income tax increases might be less damaging than further raids on businesses.

“It is not a tax which falls directly on businesses, so you would not think it would directly affect employment or investment, which are the kind of things the Government is worried about,” he says, noting that investment is critical for future growth.

Economically, then, income tax makes sense to target. Politically, however, it is toxic.

The Government’s promise not to raise the tax means it would face a barrage of attacks from its opponents if there were to be a policy reversal. A tax increase that hits the majority of the voting public also risks a slump in the polls.

However, this has not proved to be an insurmountable hurdle to date. In October 2024, Reeves stunned businesses with a £25bn raid on employers’ National Insurance contributions (NICs).

Plenty of bosses had given Labour their backing in the general election on the basis that the manifesto ruled out an increase in NICs.

Reeves claimed the language around the pledge meant she had in fact only committed to a freeze on the NICs paid directly by employees, not the larger chunk paid by their bosses.

So the manifesto has already been allowed to slip.

A similar loophole may be found on income tax. Extending a freeze on thresholds would result in workers paying more to the Treasury, but in a stealthy manner, avoiding explicitly raising headline rates.

Alternatively, the Resolution Foundation has proposed sticking with the spirit of the policy, if not the letter, by cutting employee NICs while raising income tax, by 2p each.

This would have little impact on workers, but would raise £6bn from those who pay income tax but not employee NICs – including pensioners, landlords and the self-employed.

As a result it could be seen to meet the pledge not to hit “working people”.

Ultimately, though, there are serious downsides to higher income taxes. No matter how efficient economists believe the tax to be, it is still a drain on households’ incomes.

“Whenever you raise taxes it takes money out of the economy somewhere. This time it would take money out of the pockets of working people,” says Dales.

On top of that, he notes it is another disincentive to work. It risks reducing the appeal of getting a job just as the Government needs more people to contribute to the economy.

But with no good options, income tax might just prove irresistible to a Chancellor with her back against the wall.

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