What to expect in October’s Budget following the Chancellor’s public finance update

The Chancellor has signaled to the public that tax rises are extremely likely at the Budget on 30 October, pointing to what she claims is a £20 billion black hold in the public finances.

During the election campaign Rachel Reeves and Keir Starmer, now Chancellor and Prime Minister respectively, were at pains to insist they wouldn’t raise income tax, VAT or National Insurance rates. Those are the three big taxes on income and spending, which could raise billions if increased by just a percentage point.

It’s possible to increase taxes on income through the backdoor, which is precisely what we’ve seen in the past few years of frozen tax thresholds at a time of inflation and wage rises.

That trend is almost certainly set to continue. The big question is where else the Chancellor may turn in order to ratchet up the tax take even further. The inevitable pre-Budget speculation about possible tax rises can be unsettling for savers and investors, but given the lack of certainty, it’s usually best to ignore the noise, deal with the tax rules as you find them and focus on the long term.

Where might the Chancellor turn for tax rises?

Income Tax

While the Chancellor pledged in the election campaign not to raise the rate of income tax, that doesn’t preclude extending the current freeze on thresholds, which is tantamount to raising tax by the back door. It was a tactic used by her predecessor to raise taxes on working households, with rising wages at a time of high inflation providing an added stealth tax on earnings. The effect is muted somewhat when wage rises are lower, which is to be expected as inflation comes down, but it’s still an easy way to boost tax revenues.

Capital Gains Tax (CGT)

Having ruled out increases to some other taxes, Capital Gains Tax (CGT) might appear like an obvious place for the Government to make changes and generate more tax revenue. The most radical option is equalising CGT rates with Income Tax – which would represent a huge tax increase for investors. The Office for Tax Simplification, now disbanded, has previously argued the CGT exemption was too high and that the disparity between rates of CGT and income tax distorts decision making. The CGT free allowance has been slashed in the past two years as Jeremy Hunt sought to balance the books, but that doesn’t rule out further tax increases.

However, it may not be the cash cow that many think it is. The Government’s own figures show that a big increase in CGT rates could backfire and lead to lost revenue for the Government. For example, raising both the lower and higher CGT rates by 10 percentage points, to 20% and 30% for non-property gains, would result in a total loss of £2.05 billion for the Exchequer by 2027/28. That’s because while the rates are higher, investors would be expected to change their behaviour to mitigate paying the tax.

An alternative would be to get rid of some of the CGT tax breaks for businesses, where business owners selling their company benefit from a lower rate of CGT. Raising this rate from 10% up to 20% to equalise it with standard CGT rates is estimated to generate £710m for the government by 2027/28 - but it’s clearly not a move that will be popular with entrepreneurs.

CGT being wiped out on death also creates an incentive in some cases to hold onto assets, so they are taxed as part of the estate under IHT, potentially paying less or no tax. But if the Government scrapped this tax break, there would likely need to be some allowance made to account for inflation. Otherwise, people who have owned investments for a very long time would be severely punished.

Dividend tax

The previous government has already cut dividend tax allowance to the bone, going from £5,000 to the current £500. The big question is whether Labour is prepared to go any deeper.

HMRC is expected to collect £17.5 billion from dividend tax in the current tax year so it is already a meaningful source of revenue. While slashing the allowance, perhaps to £250, cannot be ruled out, the new government would be incredibly unpopular with investors if it reduced dividend allowance any further.

Another option would be to raise the rate of dividend taxation, although there’s only so much room for manoeuvre with tax rates on dividends already very close to matching income tax rates for higher and additional rate taxpayers.

The government will likely tread carefully here. Labour wants to encourage investment into the UK stock market and create a more vibrant place for British businesses to access growth capital. Therefore, taking even more of investors’ returns as tax would mean shooting itself in the foot.

Inheritance tax (IHT)

Often cited as the UK’s most hated tax, despite only being paid by a small proportion of the population, the Chancellor could set her sights on raising money through IHT. At 40% it’s already one of the highest tax rates, so it’s unlikely we’d see a headline rate increase. What’s more likely if Ms Reeves did want to change this tax is cutting allowances or whittling away certain reliefs to increase the amount some estates pay.

A couple leaving their main residence to their children could potentially shelter a £1m estate from inheritance tax, thanks to both the nil-rate band and the residence-nil-rate band – but either of these could be cut. Another option is taking a red pen to the reliefs given to businesses or to gifting rules – although these aren’t overly generous anyway.

Stamp duty (property)

The first task Labour has to tackle is whether to extend the stamp duty breaks for first-time buyers that are due to expire next year. Currently first-time buyers pay no stamp duty on homes worth up to £425,000, but this was a temporary increase and is due to drop back to a lower limit of £300,000 from next year. The Conservatives made it an explicit manifesto pledge but it was absent from Labour’s dossier. Considering their big push so far has been boosting housing availability and getting more people onto the property ladder, it would feel odd to make it more expensive for first-time buyers. But they could argue that lowering the limit targets the support at those buying cheaper properties. Alternatively, they could opt for more radical reform rather than just adopting former Tory policy.

Another area to look out for is any hikes to stamp duty for non-UK owners. The tax rates for foreign buyers of UK property gradually increased under the Tories, and Labour could continue that trend, although in reality it isn’t a huge revenue raiser.

Pensions

Pretty much every major fiscal event over the last two decades has been preceded by feverish speculation that the axe could fall on pension tax perks. There are broadly three different avenues the chancellor could pursue if she wanted to raise cash from savers – but each comes with significant practical and political challenges.

Most controversially, government could move to restrict people’s entitlement to tax-free cash when they access their retirement pot. Currently, most people can take up to 25% of their fund from age 55 tax-free, with this minimum access age due to rise to 57 in 2028. The amount of tax-free cash most savers can take over their lifetime is capped at £268,275. Reeves could, in theory, lower the amount of tax-free cash Brits are entitled to – or even abolish the entitlement altogether.

However, this would be deeply unpopular and fundamentally undermine wider government efforts to boost long-term investing, including in UK Plc. It would also inevitably be hugely complicated, as those who have already built-up entitlements to tax-free cash under the existing rules would almost certainly need to be protected against a retrospective retirement tax. Furthermore, the overall amount people can access tax-free has already been scaled back significantly over the last 14 years, and if the current figure remains frozen, it will continue to be eroded in real terms.

The most common pre-Budget pension tax relief speculation centres around the future of higher-rate pension relief and the potential to introduce a flat rate of pension tax relief. At the more extreme end, this measure could see pension tax relief restricted to the basic rate of 20% for all, with advocates suggesting this could raise billions of pounds of extra revenue for the Treasury.

However, as with most radical pension tax changes, introducing a flat rate of relief is much easier said than done. A huge chunk of any potential savings to the Treasury from a pension tax relief raid would come from defined benefit schemes, the majority of which now reside in the public sector.

If a flat rate of pension tax relief below 40% were applied on these schemes, the only way to ensure the correct level of tax relief was applied to contributions from higher and additional-rate taxpayers would be to hit those members with a tax charge likely running into thousands of pounds. This would therefore risk opening a blistering row with NHS staff and civil servants at a time when many public services are already stretched to breaking point.

Lastly, the tax treatment of pensions on death will be viewed by many as low hanging tax fruit ready to be picked. Under existing rules, it is possible to pass on your retirement pot completely tax-free to your nominated beneficiaries if you die before age 75. If you die after age 75, any inherited pension is taxed in the same way as income. Crucially, pensions usually don’t form part of people’s estate for inheritance tax (IHT) purposes.

This is undoubtedly a generous set of rules and something which could easily be reviewed by the new government. However, as is often the case with pensions, applying any new tax on death – or bringing pensions into the IHT net – would come with substantial challenges.

The biggest of those would be around how to treat people who have made decisions about their retirement pot based on the pensions death tax rules as they are today. There will, for example, be lots of people who chose to transfer defined benefit pensions into a defined contribution scheme in part because they wanted to prioritise passing money on tax efficiently to loved ones.

If all of a sudden that money became subject to a new pensions death tax, those people would, understandably, feel like the rug has been pulled from under them.

It is therefore possible a complicated protection regime would be needed to ensure people are not subject to unfair and arguably retrospective tax measures. This would inevitably reduce the money the Treasury could potentially raise from such a move.

Potential cost pressures on the public purse

Public sector pay

Keeping Britain working is likely to be at the forefront of the Chancellor’s strategy for growth.

Industrial action was consistently cited as a reason for supressed growth last year in the Business Insights and Conditions survey carried out by the ONS.

It’s not surprising that one of the new Labour government’s first moves has been to ensure industrial relations with public sector workers are put back on a more secure footing by accepting recommendations on public sector pay.

Whilst not securing a satisfactory pay deal would undoubtedly have costly repercussions, finding the cash to cover the extra cost of meeting recommendations comes with its own issues.

The prospect of higher-than-expected pay rises is likely to factor into interest rate decisions taken by the Bank of England’s MPC both this week and in the coming months.

Whilst the public sector is playing catch up with its private counterpart, the improved landscape is likely to play into decisions by private sector bosses considering the strength and loyalty of their workforce over the next year.

As with any decision a slight shift from what had been anticipated can tip the balance, something which no tightrope walker ever wants to contend with.

National Living Wage

There have been plenty of concerns raised by employers having to factor in this year’s near 10% increase in the National Living Wage and its expansion to cover those aged 21 and 22.

Businesses, still reeling from the impact of blistering inflation over the past couple of years, are under pressure from price sensitive consumers not to pass on their increased costs.

During the election campaign the new government set out its plans to make work pay, plans which look set to scale back the difference between the amount received by under 18s and the full whack paid to their over 21 counterparts.

It also said it would direct the Low Pay Commission to take into account the cost of living when it comes to setting the rate which should come into force next April.

Full details of this particular path are expected to be delivered by the Business Secretary tomorrow.

Ensuring a day’s work covers the basics makes sense, both in terms of putting more cash into people’s pockets to spend and from a moral perspective. Working families simply shouldn’t have to rely on foodbanks in 21st century Britain.

But just as the Treasury seems to be staring into a sizeable black hole, many employers are facing the same, uninspiring view.

Push them too far and some might find the extra pressure forces the doors shut on many businesses struggling to keep them open.

Infrastructure projects

Filling what they’ve termed a ‘black hole’ won’t be easy especially since the government’s already ruled out many of the most obvious solutions.

Scaling back or pulling the plug on projects that had been green lit by the previous government is a quick fix, but it sits uncomfortably with Labour’s ideological plans to get the economy growing.

Offering stability and clear direction has been widely credited with increasing business confidence, confidence that will be crucial if Rachel Reeves is to persuade the private sector to invest in UK plc.

Ripping up plans in the first halcyon days don’t look good.

They suggest that business can’t rely on the government to follow through, albeit the Chancellor will argue the projects being ditched weren’t Labour promises and that the money earmarked for them would be better spent in other areas which would reap bigger rewards.

But for those businesses that had skin in the game, it might feel like the new boss doesn’t seem to be a whole lot different than the old boss.