Merlin Weekly Macro: Labour’s backbenchers in the fiscal driving seat

Reflections of a Product Specialist

Merlin Investment Director Alastair Irvine, your correspondent in these weekly musings, also writes a Friday blog for internal consumption only, now in its 11th year and 430 editions later, the unimaginatively titled but eponymous ‘Irvine’s Insights.’ Almost exactly a year ago, he penned the following:

“Coming over all Pink: what on earth has happened to me in these last few days before the election? I seem to be having an out of body experience. A banner from Islington someone has taped to my desk shouts ‘VOTE CORBYN!’; this week I’ve found myself on two mornings buying the distinctly left-of-centre New York Times (to the point on the second morning the nice man on the till in WH Smith at King’s Cross raised an eyebrow and said ‘really?’); on Tuesday, I listened to St Tony Blair on Radio 4 and thought, you’re right, you’re absolutely right, you’re making sense to me, let’s have you back. Not quite the colour of a pillar box, nevertheless I seem to have developed a politically pale pink hue. It’s deeply unsettling. It must be my natural libertarian tendencies (no guffawing at the back, thank you).

For God’s sake, Alastair! Wake up! Snap out of it! You’re supposed to be a True-Blue Thatcherite Tory. You’re ‘Scum!’ and proud of it, remember? Your daily diet is the Torygraph. You’re a minority species on the verge of extinction. You wear sober suits, shirts with stripes, Hermes ties, Marks & Spencer underwear and sensible shoes from Trickers. You use a fountain pen, carry an umbrella come rain or shine and a briefcase. You shoot in tweed plus 4s and fish in an old smelly, battered Solway Zipper, a jacket so thick with wax it stands upright unsupported in the cold and which Barbour stopped making three decades before they had any inkling of the term ‘fashion label’.  You need to get a grip, my boy, and soon, otherwise before you know it you’ll be reading The Grauniad, drinking carrot juice, driving an electric 2CV and voting for Starmer. And that really is a step too far.”

Testing beliefs

Quite unwittingly 52 weeks later, alongside his daily diet of the Telegraph he has again bought the New York Times; not only that but The New Statesman too, the house periodical of the Left in the way that The Spectator cavasses the Right. Catching his eye on the front page of the NYT, again at King’s Cross WH Smith, the rug-pulling headline from what should be a naturally supportive paper, “Keir Starmer seems to be fading away” and the by-line “Britian’s Prime Minister was supposed to write a new chapter. He might end up a footnote”.  Your correspondent didn’t need his glasses to get the hint of the New Statesman’s message: in blending black, burnt umber and blood red capital letters, the front cover screamed “JUST RAISE TAX!”. Relieved of £9.45, both were nevertheless instant and irresistible purchases.

Self-caricature, exaggeration and jesting aside, in the investment world it is always important to consider perspectives through lenses other than your own. Conviction is a precondition for success; that goes without saying, otherwise the tendency is towards consensus. Consensus and conforming to the benchmark are the enemies of outperformance. But perspectives that challenge what can become prejudices and dogma are important as a sense check that one’s critical thinking remains rigorous, principled and tested. Even if you arrive at the same conclusion, you can demonstrate how and why having been challenged by the alternatives.

House organ leads the witness

Which brings us to The New Statesman and taxation. A long analysis by columnist Will Dunn argues entirely correctly that UK tax regulations, in all comprising a ‘handbook’ running to 23,000 pages (16 times the number in the Oxford Classics paperback edition of War and Peace), are arcane to the point of absurdity: “an ice-cream cone on its own is classed as a biscuit and zero-rated for VAT, unless it is covered in chocolate in which case it stops being a biscuit for tax purposes, or until such time as a scoop of ice-cream is placed into it at which point it becomes a taxable dessert (unless it is a chocolate-lined waffle basket of a size that would make it--to quote the tax code--‘quite difficult, though not impossible, to hold in the hand and eat it’)”. It is an HMRC job creation scheme maintaining the rule book and a tax lawyer’s lifetime annuity providing advice on how to navigate it.

But Dunn’s central premise is that the tax system is unfair, that National Insurance is a con and, critically, that the asset-wealthy and those benefiting from ‘unearned’ income not only get off lightly but have somehow cheated the system (to which end, private landlords are squarely in his sights). He correctly points to inverse relationships notably Council Tax rising inexorably for which local services such as bin collections decline in frequency or efficacy. He pins the blame squarely on the delegated burden and faster rising cost of locally funded social care. He failed to point out that as revealed under a Freedom of Information request, the Daily Telegraph was able to establish that one council, the Shetland Islands, puts 111% of its annual tax revenue into its staff pension scheme; four councils (Hackney, S Oxon, Newcastle-under-Lyme and Orkney) pay over 50% and another 19 authorities contribute over a third of their tax income to pensions. UK-wide, 60 councils pay over a fifth. Far from a progressive policy, it is the definition of regression: a rising cost to support a public sector cohort whose productivity is in decline. 

Wealth taxes are clearly on the agenda. Neil Kinnock advocated for them this week from his unelected, politically secure seat in the House of Lords. At the most recent Prime Minister’s Questions, when challenged directly on the subject, in what even for him was a particularly oblique non-answer to a closed question, Keir Starmer failed to rule them out. Of course, we already have one: by the way it is levied (bands based on value differentials, though not nominal property values), Council Tax is a variety of wealth tax in principle. Dunn notes that wealth taxes have largely been unsuccessful revenue-raising instruments elsewhere yet insists that while he would abolish Council Tax and Stamp Duty, he would replace them with a land tax based on nominal values (echoes of John Prescott’s bid in the Blair government to tax the development potential of gardens and to put a taxable value on the view from the house, and surely the death-knell of farming).

But Dunn’s central solution is simple: higher and more ‘progressive’ Income Tax. He would add 5p in the pound to Income Tax rates and eradicate employees’ NI. Changing the rates of Income Tax has been ruled out by Rachel Reeves, along with the rates of employees’ NI and VAT.

Tax-raising alternatives of all varieties (no doubt even testing the sanctity of the IT/NI/VAT holy trinity above) are in the melting pot over the summer. Reeves has an October deadline to square the fiscal circle at the Budget. It is a near impossible task without breaking something: her promise with the electorate over taxes; her credibility with the bond markets if she breaches or dilutes her fiscal rules; her pact with the unions about pay as the junior doctors vote again for strike action. The one constituency with whom there is nothing left to break is Labour MPs; that trust on spending cuts is broken already from which there is no coming back: after Starmer’s colossal cave-in over benefits, for whatever fiscal solutions she arrives at, Labour’s back benchers will decide what is permissible.

Reeves: institutional pain piles on

If last week was excruciating for Reeves and the government, her own woes have only got worse this week. The Bank of England pointed to the fragility of the bond markets in its latest Financial Stability Report: that’s about the near-term, a borrowing crisis and a possible bond sell-off drawing embarrassing parallels with what happened under Kwasi Kwarteng and Liz Truss. The Office for Budget Responsibility also weighed in about policy failure rather than merely the symptoms thereof. It alerted the Treasury that the UK’s economic fabric is “vulnerable”. It specifically draws attention to the unaffordability of the pensions triple lock, the ballooning benefits bill, meeting the new defence budget and implicitly criticises the June Spending Review when pound notes fell out of Reeves’s purse in an almost never-ending torrent of largesse. This adds to the Bank of International Settlements last week saying that our fiscal trajectory is ‘unsustainable’.

Let us not beat about the bush here: dressed up in economic euphemisms and diplomatic understatement, what the OBR and BIS are both saying is that structurally and strategically we’re in sight of going bust. Government bond yields rose again and remain above Reeves’s tearful appearance in parliament last week, at the long end close to 20 year highs.

Lending credence to a flawed but convenient conclusion

The political thinking of Dunn and his ilk is seductive. Lending it substance is an undeniably plausible generalised thesis: more than a decade of ultra-loose central bank monetary policy (almost zero interest rates and excess liquidity, together known as quantitative easing) spanning the end of the Global Financial Crisis and the pandemic/Putin inflation hump caused the prolonged phenomenon of all asset values correlating positively and simultaneously (i.e. all going up at the same time). The already asset rich became effortlessly and for a time almost risklessly wealthier; those without assets experienced no benefit but saw real-terms declines in incomes thanks to increasing economic inefficiency and the insidious development of the ‘zombie economy’ (with the cushion that during the pandemic incomes were protected at 75% of existing salary through the furlough and business continuity loan schemes). But truth and perception become indivisible: the ‘haves’ were seen to make off like bandits while the ‘have nots’ were left in penury.

The counterpoint is equally valid: in the half-decade since the pandemic, society has become more fragile as measured by the rapid rise in people on benefits citing mental health issues, and we now have a substantial proportion of working age adults who are economically inactive by choice rather than through enforced circumstance.

There are two sides to the same coin labelled ‘feckless’. The Left sees the wealthy as undeserving: the feckless ‘idle rich’ in populist language, or not ‘working people’ in Starmer’s playbook; the Right has a different perspective on fecklessness: an entitled and growing cohort of the workshy, oozing rights without responsibility, taking everything they can get from the state with no intention of making any contribution to society. Whatever grains of truth or falsehood and exaggeration in both points of view, both are simplistic, reductive and unhelpful arguments.  

But at this stage in the political cycle, there is a pernicious truism: as Starmer has painfully found out, once they have been not only made available but given willingly in abundance, it is impossible meaningfully to reduce state handouts without policymakers being shot down in parliament. On the other hand using the agency of a parliamentary majority and the blunt instrument of enforced taxation, the temptation will be to redistribute (i.e. confiscate) surplus wealth, defined by an arbitrary minimum, through capital taxes on property, securities and pensions, and to impose variations on income and inheritance taxes; the deferred political consequence is a calculated gamble at the ballot box based cynically on it benefiting many but inconveniencing few.

Socialist ideology: demolishing faltering footings….

But however much extra tax revenues might plug a short term funding gap and address the Bank of England’s immediate criticism, when mitigating against the warnings of the OBR and BIS (to which add also the IMF) it is plain that ideology such as Dunn’s and Kinnock’s is fundamentally flawed. Its founding supposition is the socialist supremacy of the state, not the supremacy of the individual. There is no attempt whatever to address state spending, it is entirely driven by equalisation and the redistribution of wealth (it is not too strong to say the far-Left despises the accumulation of wealth). The state determines what it deems reasonable allowable income and capital wealth beyond which it has the right of confiscation; it will then disburse the surplus accordingly to what it sees as the benefit of the greater good. If it needs more, it will take more (Kinnock suggests a 2% levy per excess million pounds on aggregate assets beyond a £10mpc threshold; but if state ‘needs’ expand, who is to say it might not be tweaked say to 2.5% on sums over £9m? It seems insignificant but if an individual had £12m, on the first basis the annual tax liability to be paid in cash would be £40,000, on the second the annual liability would nearly double to £75,000).

Based on the simple question, “do you really need that much money?” to which the pre-determined answer is “no”, what follows is linear: as even wealthy individuals are likely to have to sell assets to raise cash to pay the tax, the continuity of capital breaks. It has already been undermined by Reeves removing the IHT shelter from business and agricultural assets. As the incentive to take investment risk diminishes knowing the rewards are going to be appropriated by the state, the oxygen of capital will gradually be sucked out of the system. The private sector deflates and the public sector is needed to do more of the heavy lifting to maintain some semblance of progress. But the public sector essentially recycles taxpayers’ money with negligible economic benefit. The system degenerates into an inescapable vortex of mounting debt and accelerating decline. At best, economic extinction is a real risk; at worst it is a self-fulfilling prophesy.

And building new secure foundations

The alternative, the one that is currently politically impossible but for all that no less imperative, is to re-set the relationship between the individual and the state, both in terms of expenditure as a percentage of GDP on public services and reducing the burden on the electorate measured as the percentage of GDP met by taxation. Define the tightest limits for what the state must provide (defence, law & order, the state pension, the minimum safety-net for the genuinely incapable) for which taxes are raised, but allow alternative funding and delivery models for everything else. Those other services still need paying for but consumers are allowed choice. The two shibboleths needing dismantling are the health and benefits systems.

As the balance redresses between the state and the individual, so taxation rates can be reduced. With greater disposable income it is then a matter of choice again as to whether what is freed up is channelled towards consumption or investment for which there should be targeted incentives. As the economy gradually rebuilds a natural momentum through a vibrant private sector, the economic and financial jigsaw rapidly completes a coherent picture: the large pool of unproductive labour can be drawn back into the workforce both for its own benefit and the greater good, reducing the financial burden on the state; a growing economy even with lower rates of applicable tax empirically produces greater nominal tax income; the debt rapidly begins to fall while GDP is rising, so not only does the debt mountain decline but so too the interest paid away to support it; as for debt/GDP ratio, that is a double win as the numerator falls while the denominator rises simultaneously; the country becomes highly attractive to foreign inward investment based on stability and decent returns. Governments are back in control over events rather than at their mercy. The opposite of an inexorable vortex, the economy becomes a virtuous cycle. The country is back in business.

But it requires its own linear political logic. The political case for radical economic reform has to be made first based on rigorous, first-class academic thinking mixed with practical solutions. Then it requires political bravery and leadership to see them through and a hard-headedness not to give in. Starmer failed with his own benefits reform because he was on the back foot from the start: it was not in the manifesto; there was no mandate for it; it went against all his socialist instincts and those of his MPs; he had painted himself into a corner because the changes he was proposing were ones he was forced to make because of his own failures elsewhere, they were not ones he wanted to do deliberately on principle.

We need to go back to the future

Whether you loved them or loathed them, disassociate the personalities (they’re almost all dead, including Norman Tebbit who died this week) and consider the skills and qualities of which we are so desperately in need today. In the lead-up to 1979 when we were also in a mess, it was the academic rigour of monetarist economist Alan Walters combined with the political acumen and detailed strategic thinking of MP Keith Joseph under the robust, confident leadership of Margaret Thatcher who paved the way for an economic revolution. It took a while and there was much resistance but gradually the electorate bought into it. It took the hutzpah of people like Michael Heseltine, the nous of Nigel Lawson and the grim, no-nonsense determination of enforcer Norman Tebbit to see it through (that Thatcher later succumbed to hubris, almost blind self-belief and mistrust of her colleagues, illustrates another political truism: in Westminster politics, few leaderships endure or end well on the leader’s own terms).

These were the political giants of their age. Few hewn from similar rock are in evidence today. Which brings us back full circle to that headline in the New York Times: he and we will be getting away lightly if Sir Keir Starmer only “fades away” to become a “footnote in history”. What the Bank of England, the BIS, the IMF and the OBR are warning is that on his current trajectory he is knowingly presiding over an incipient economic collapse, even if the final denouement is not on his watch. As an agent of decline, far from a footnote, for all the right reasons he would deserve a chapter all of his own. The heading should be “Pitfalls and Pratfalls to be Avoided for Future Prime Ministers: Lessons of the Starmer Era”.

As for the rest, it is not just about ensuring we avoid the rocks, it is about charting a whole new course for enduring prosperity. All we need now is a first rate skipper, an experienced fully qualified navigator and some bright, intelligent senior officers who between them know precisely where they want to go and exactly how to get there. The rest of the crew will quickly fall in. Go find.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.