Britain’s Labour Party bets on big taxes, borrowing to boost economy

Standing in Parliament, Chancellor of the Exchequer Rachel Reeves Wednesday said her government will raise taxes by £40 billion, equivalent to around $51.9 billion, one of the biggest tax hikes in a generation, and borrow billions in the coming years to invest in the country’s infrastructure.

Labour is betting that an injection of state funds can end a decade of low growth by kick-starting business investment while extra tax receipts are used to patch up Britain’s public services. “The only way to drive economic growth is to invest, invest, invest," she said, pledging to increase capital investment by £100 billion over the next five years.

The announcement marks a further shift in British government orthodoxy away from a smaller state and toward more European levels of state spending. It also marks a shift in tone: Previous Conservative governments also ended up hiking taxes to keep public finances steady, but vowed to bring them back down. Labour is indicating they are likely here to stay.

The plan isn’t without risk. Business groups have warned that the higher taxes, which largely land on the shoulders of employers, could end up deterring hiring and investment. The U.K. government’s long-term borrowing costs crept up slightly in the weeks before the budget announcement as investors digested the likely scale of debt issuance needed to fund the plan. U.K. government debt yields fell slightly after the budget was announced on Wednesday.

Economists aren’t expecting a big impact on growth unless private-sector investment also grows. An independent budget watchdog, the Office for Budget Responsibility, said Wednesday it forecasts the U.K. economy will grow 1.1% in 2024, and 2% in 2025. Growth would remain below 2% through 2029, it said.

Since coming to power in July, the Labour government has argued that it was time to be realistic about the scale of funding needed to sustain Britain’s welfare state as it manages an aging population and growing demands to spend big on healthcare and defense. The previous Conservative government had penciled in sweeping cuts in public services over the coming years to balance the books.

Rather than go through with the full scale of cuts, Reeves has raised taxes instead. “Any responsible Chancellor would need to take difficult decisions today to raise the revenues required to fund our public services," she said.

The tax rises announced Wednesday were calibrated to land mostly on businesses and the wealthy. There will be an additional levy on payroll taxes paid by businesses to raise £25 billion a year, and a tax rise on capital gains, which are profits made from share sales. Other tax increases covered inheritance tax, the sale of second homes and private air travel. The Treasury also announced that the minimum wage level paid to workers would rise next year faster than inflation.

The U.K.’s strategy goes against the grain in Europe, where states are generally tightening their belts to pay for years of big-ticket outlays following the pandemic and an energy-price crisis caused by the war in Ukraine. France’s government has announced big spending cuts in its budget for next year, while Germany’s government is also cutting outlays despite having a much smaller debt than its peers.

In the U.S., the government has opted for large-scale borrowing without raising taxes.

“The major legacy of this budget will be an increase in the size of the state," said Andrew Wishart, economist at Berenberg Bank. “That will resolve a long-running tension between the UK’s desire for European welfare and public services at U.S. tax rates."

Reeves said the borrowing will help fund Labour’s longer-term industrial policy, which she says will help break a cycle that has plagued European governments: slow growth that leaves governments short of the money they need to keep up public services.

Hanging over the government are worries of a repeat of 2022, when the pound crashed after then-Prime Minister Liz Truss signed off on unfunded tax cuts combined with big borrowing. Truss was ejected from Downing Street within weeks.

Economists have long pointed to anemic levels of both public and private investment as a major reason for Britain’s sluggish growth. Much of the top-line economic growth over the past 16 years has been driven by adding more workers, partly through immigration, rather than making existing workers more productive. U.K. output per person grew by just 5.6% between 2007 and 2023, compared with 20% in the U.S.

Britain has long invested less than its peers, devoting just 17.8% of economic output to that purpose in the three months through September, compared with 21.3% in the U.S. and 24.7% in Japan.

Any attempt by the government to hike public investment without creating incentives for the private sector to invest will likely fail in boosting long-term growth, economists say.

To allow for the extra borrowing, Reeves is junking previous government borrowing rules to exclude items such as student loans. To try to temper investors’ nerves, the government also announced a new rule: that borrowing wouldn’t cover the state’s day-to-day outlays.

Britain’s state is far smaller than its European neighbors but it has been expanding fast in recent years.

In 2022, the most recent year for which comparable figures are available, U.K. government tax revenues were 35.3% of gross domestic product, well below 39.3% in Germany and 46.1% in France. In the U.S., tax revenues were equivalent to 27.7% of GDP.

According to the Organization for Economic Cooperation and Development, the U.K. economy was just 2.9% larger in the three months through June than it was before the Covid-19 pandemic struck, lagging far behind the 10.7% growth recorded by the U.S. over the same period. Among the U.K.’s peers in the Group of Seven, only Germany had a weaker rebound.

Write to Max Colchester at Max.Colchester@wsj.com and Paul Hannon at paul.hannon@wsj.com