Labour’s economic tightrope: the UK's stagnating economy needs stimulation, not spending

“When the economy is strong, the deficit will be lower as tax receipts increase and welfare spending costs are reduced. The opposite is true when the economy is weak.” – OBR

This piece explores Labour’s current quandary. Navigating its welfare state through a period of recovery that requires tighter spending while trying to motivate the populous to generate more taxable income. To manage the deficit, Labour either has to raises taxes by rates or stimulate the economy to become more productive thus increasing tax receipts via larger profits.

The issues are myriad. Taxpayers are faced with less bang for their buck, as the standard of living and quality of public services is not rising with increased taxation as it should. This makes increasing tax rates wildly unpopular. What's more, in this economic climate, raising tax rates on businesses has also demonstrably contracted the economy (May 2025's 0.1% contraction), stunting the economic growth so desperately needed to stimulate more profits and higher salaries. UK productivity data already verges on dire; the OECD tells us that real output per hour has risen by just 6% since 2007 in the UK – compared with 22% in the U.S and 10% in the Eurozone.

As the FT describes it, the UK’s stagnating productivity makes us ‘zero sum’; one for more group means less for others. Labour’s welfare policies being met with outright rebellion (by the way, furthering the perception that the UK is volatile thus pushing Gilt yields and hampering national debt serviceability) forces Labour to balance the equation by increasing the national income – and that is tax receipts. If we aren’t growing, Labour can only increase tax rates.

I remind you here of yet another balancing act: the income substitution effect commonly referred to in tax economics. Income tax can reduce labour supply where tax hikes make work less attractive relative to leisure (as after-tax wages are lower); versus the income effect, which encourages more work to maintain the same income level. Will further tax hikes cause contributors to the economy (SMEs, individuals) to give up or worse move abroad?

An increase in productivity is required during a time where goods and services have seldom been so perceptibly (and genuinely) unaffordable. Purchasing power is much lower due to inflation, increased wages are hammered by NIC hikes cutting profit, and base rates feel unrelenting – at present, stagnating real incomes make increased productivity hard yards.

It does stand to reason that Rachel Reeves’ tax policy to date, particularly the impact of her business taxes and the refusal to denounce a personal tax band freeze, has been deeply unhelpful. But in a stagnating economy, where else is she to turn, given that cost cutting is unpalatable to her party?

The answer to the above presents itself: seriously consider how to stimulate growth.

Reeves is called to focus on dismantling barriers to growth in order to lessen the deficit – by stimulating an increase in profits that will enhance tax receipts on an income basis, not a rates basis. This avenue must be given serious consideration if stagnation is to be tackled; as Mohamed El-Erian writes for the FT – “plac[e] innovation policy more firmly at the centre of an even more aggressive and frontloaded growth strategy”.

It goes without saying that more spending will equate to more deficit, worsening the position the UK already finds itself in not only in terms of the deficit but also the impact that this type of policy will have on Gilt yields, as the markets price in the cost of bad policymaking.

How do Gilt yields play a role here?

UK Gilts are one of the most sensitive government debt markets of the developed economies. Is this because a welfare government is navigating the impossible, and investors are waiting for cracks to form? Yes. As eloquently observed by the FT, Labour MPs are viewed as ‘fiscally incontinent’. It is also in part the shadow of Truss’ 2022 mini-budget in which we continue to live, with investors quick to take cover.

Fundamentally markets need to perceive the UK as a growing economy with fiscal control which, as set out above, is a challenging view to take with a Labour government.

Labour’s focus should be on stimulating the economy by removing barriers to growth, encouraging innovation, and empowering UK business – not on crudely taxing them more.

It is worth noting that should base rates take a more accelerated downwards trajectory – which is an acute balancing act with inflation for the BoE as explored in previous posts here – the world should feel brighter and we may see green shoots as a result.