The UK faces a persistent savings deficiency which, at the present time, is the primary constraint hindering domestic investment. While Labour’s budget aims to boost growth, its pledge to avoid key tax increases limits the ability to raise savings. Without higher savings, the government will struggle to prevent continued economic underperformance and attain its core missions, writes Dimitri Zenghelis.
In my previous blog, I outlined how and why the new UK Labour government had struggled to boost UK domestic investment and economic prospects.
When demand is weak, capital is cheap and inflation is dormant, additional UK investment can be funded by borrowing from abroad without an increase in household saving. But when inflation remains a concern, an active and operationally independent Bank of England will raise interest rates and so ‘crowd out’ increased UK investment unless UK saving increases.
This underlying problem is not new. The UK has a history of over-consumption relative to the global average, with one of the weakest saving rates in the G20. This is reflected in a persistent current account deficit required to fund the excess of investment over saving (see Figure 1). A prolonged deficiency in saving results in vulnerability to shocks, insufficient retirement funds, and implies that the returns to UK investments accrue to savers overseas who increasingly own the assets.
Figure 1. Gross national savings rates and total investment rates for selected advanced economies, averages between 2010 and 2023
Note: 2023 values are estimates. Investment is defined as Gross Fixed Capital Formation.
Source: IMF International Financial Statistics database, 2024
Reeves’s economic programme for growth is in trouble and deficient saving is at the heart of the problem. So what should she have done and is it too late to change course?
The original sin at the core of Labour’s policy problems is its manifesto commitment to rule out increases in key taxes such as Income Tax, VAT, National Insurance and Corporation Tax, which account for 75% of public revenues. Most of the impediments to transforming the UK economy stem from this pact with the electorate: a Faustian deal to secure power, under which it cannot execute its core mission because of the macroeconomic realities.
In the short run, taxing consumption is the surest way to create space for UK investment by boosting saving.[1] Value Added Tax (VAT) – a general tax on consumption – would be the most appropriate instrument. The UK still has more VAT exemptions than most countries. These distort spending and raise administrative costs. The poorest households could be amply compensated for any loss through other payments, which leave them better off while still yielding net tax revenue.
Instead of spreading the cost of additional public investment thinly across society, incentivising individually small but collectively large increases in saving, Reeves was forced to do the opposite and burden a small set of investors, savers and businesses with substantial tax increases. Many of these are the very sectors that are required to boost investment and growth. Businesses face an estimated £25bn annual bill from the extra national insurance contributions alone.
As the OBR forecasts showed, by sticking to those election pledges, Reeves had no choice but to undermine many of the positive growth impacts her budget measures could have entailed.
The government still has an opportunity to address the UK economy’s medium term structural shortcomings as outlined clearly in Reeve’s November 2024 Mansion House speech. For example, building more homes may encourage saving, if they moderate the rise in house prices, while digitisation and AI could improve revenue collection.
Reeves recognises that reforming the pensions system is essential to make better use of existing savings and create funds for additional investment, thereby enhancing both prosperity and security. Yet, fearing of a backlash from business following the impact of budget measures, the government this month put on hold its review of pensions, which included a sensible plan to raise the minimum auto-enrolment level to up to 12% to boost domestic saving.
Taxing ‘bads’, like fossil fuel pollution, unhealthy food, gambling and tobacco might also have help encourage saving. Yet her Budget decision not to lift the freeze on fuel duty, even when oil prices are moderating, suggests the Government is not ready to make politically unpopular choices. Less consumption is unavoidably politically unpopular, but it is also a currently prerequisite for more investment and growth.
The risk is a doom loop whereby failure drives a defensive and electorally insecure government to become systematically incapable of driving economic change. This may sound overly pessimistic, but at the time of writing the government was clawing back its reform agenda while inflation was accelerating following two consecutive months of falling GDP and corporate confidence continued to tank.
Without measures to encourage domestic saving and spread the burden of paying for public investment, Reeves’s attempts to lift the UK’s investment and productivity growth seem destined to fail.
It is not too late for a course correction. Resolving the UK’s saving problem is a prerequisite to boosting long term growth. This is basic macroeconomics, exemplified in (November) Budget 2024. If her economic strategy is to stay afloat, Reeves must make those tough choices. Another five years of economic of underinvestment and underperformance is not a recipe for electoral success.
Read the first part of this blog: Despite best efforts to boost UK investment, election pledges are holding the government back
[1] Any such tax increase need only be temporary, as the cyclically adjusted change in discretionary net public borrowing—a gauge of the net injection of public spending—starts to come down in the second half of the parliament.
Image: Zara Ferrar/10 Downing Street, OGL 3 http://www.nationalarchives.gov.uk/doc/open-government-licence/version/3, via Wikimedia Commons
The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.
