Economic Commentary - Will growth pick up under Labour?

In this month’s commentary our Chief Economist, Colin Warren, looks at some of the factors behind the UK economy’s poor performance in recent years and the prospects for a pick-up in growth after the forthcoming election. 

Opinion polls indicate that the Labour Party, led by Keir Starmer, is on course to win the election on 4th July, ending 14 years of Conservative rule. However, Starmer will face a far more challenging economic legacy than the one Tony Blair inherited in 1997. Economic growth is sluggish, public debt is close to 100% of GDP1, the tax burden is at a 70-year high2, and voter satisfaction with the quality of public services is low3.

In this month’s commentary we look at the performance of the economy under 14 years of Conservative government and consider whether, given the considerable challenges the economy faces, growth is likely to pick up under Labour in the next parliament.

The UK’s low growth problem

Economic growth is key for the nation’s material wellbeing. Growth enables the living standards of individuals to improve over time, and rising GDP helps generate the taxation revenues on which good quality public services depend.

The problem is that the UK has experienced a marked deterioration in trend economic growth in recent years. Annual average growth from 1997 to 2010, when Labour was last in power, was just over 2%4. However, during the period 2010 to 2023, the pace has slowed to 1.5%5. Moreover, this growth has been flattered by an increase in population, that has primarily come about because of immigration. Real GDP per person only rose by 0.9% per year on average from 2010 to 20236.

Of course, this period includes the pandemic and the energy shock resulting from the war in Ukraine, factors which dragged on activity and raised inflation, prompting the Bank of England to sharply raise interest rates.

However, there is little doubt that policy decisions under the Conservatives have also contributed to weak economic growth. Despite record low borrowing costs in the wake of the Great Financial Crisis (GFC), the Conservatives, under the leadership of David Cameron, drastically cut public investment during 2010-16 as part of their deficit reduction programme. Moreover, the aftermath of the Brexit vote in 2016, and the chaos of the Liz Truss mini-budget, created a climate of uncertainty, which has depressed private sector capital expenditure.

In turn, low levels of public and private investment have weighed on productivity growth. During the period 2010 to 2023 average annual labour productivity growth in the UK was 0.6%, below the 0.8% average of the UK’s G7 peers7

Although it is difficult to disentangle the impact of policies, there is little doubt that Brexit has had a negative impact on UK growth and productivity. The Office for Budget Responsibility (OBR, the independent budget watchdog) estimates that Brexit will reduce long-run productivity by 4% relative to remaining in the EU8

The policy response to the pandemic has also probably been a contributing factor. Although Prime Minister Rishi Sunak has been keen to remind voters of the generous furlough scheme he introduced during the Covid crisis, there is some evidence to suggest that the policy, while protecting jobs, may have slowed productivity by keeping workers in less productive roles9. In contrast, countries like the US that allowed greater labour market flexibility saw quicker rebounds in activity and productivity in the wake of the pandemic.

Shocks abating

Going forward, the question is whether growth will improve under a future Labour government.

Prospective policy changes aside, there are some reasons for optimism. The drags on activity from the external shocks of Covid and the war in Ukraine are abating. With inflation dropping from over 10% in 2022 to nearly 2% currently, real (after inflation) earnings growth has turned positive following recent declines, reaching 2.3% in April, the strongest level since August 202110.

Moreover, given that UK companies expect wages to rise by around 4.5% over the next 12 months11, and the Bank of England is forecasting inflation near to its 2% target12, real wage growth of close to 2% is a reasonable expectation for the next year at least. Consumer confidence has risen to its highest level since December 2021, suggesting that household spending should strengthen going forward13.

Falling inflation should also enable the Bank of England to reduce interest rates from their current 5.25% level14, although stubborn service sector inflation and the risk of a reacceleration in prices will make policymakers wary of sharp rate cuts.  Financial markets currently anticipate that the Bank’s policy rate will bottom out at around 3.5% during the coming rate cut cycle, suggesting that borrowing costs are unlikely to return to the pre-pandemic lows of sub-1%15.

In addition to lower interest rates, we noted in our commentary of April 2024 that a more stable political environment under Labour could provide a better environment for business investment after the election. However, as we pointed out then, supply side reforms and Labour’s relatively timid proposed changes to the planning system will take time to bear fruit and might not make much impact during the next parliament. Labour has ruled out rejoining the EU, and its plans to improve workers’ rights, while a potential positive for consumer sentiment and productivity, could make companies wary of hiring.

Fiscal constraints

Given that Labour has signed up to the Conservatives’ fiscal mandate (i.e. that debt must be falling as a share of the economy by the fifth year of rolling official forecasts), and tax hikes and spending cuts are already pencilled in for the next parliament, fiscal policy is unlikely to boost growth in the coming years.  

The tax burden is set to rise. Labour have pledged not to hike income tax, national insurance, and VAT. However, the party’s manifesto outlines plans to raise tax revenues by £8.5 billion a year via a clampdown on tax avoidance, along with higher taxes on energy companies, private schools, non-doms and private equity managers. 
According to the Resolution Foundation, Labour’s tax hikes, along with the £23.5 billion of post-election tax increases already announced by the outgoing Chancellor Jeremy Hunt, will result in the UK’s tax-to-GDP ratio rising from 36.5% in 2024-25 to 37.4% in 2028-29. This said, the projected 0.9 percentage point rise in the tax burden is considerably lower than the 3.3-point rise witnessed in the last parliament16.

Labour’s commitment to be fiscally responsible means that there are no plans for a big increase in public spending either. The Institute for Fiscal Studies (IFS) notes that Labour’s manifesto pledge to increase day-to-day public spending by around £5bn by 2028-29 equates to an annual real (i.e. after inflation) increase of just 1.2% (versus 1.0% under the outgoing government’s plans)17

As much of this increase is allocated to ‘protected’ areas of public spending (notably the NHS and education), ‘unprotected’ departments (including transport, local government, and prisons) would face real terms cuts of between 1.2% and 2.9% according to the IFS. Starmer has vowed there will be ‘no return to austerity’, but avoiding such real-terms cuts will require top-ups of £6-16bn according to the IFS. These calculations suggest that a Labour government would have to raise taxes more than they have outlined in the manifesto, further increasing the tax burden.

In the area of capital expenditure, Labour plans an increase in public investment of around £5bn a year by 2028-29, mainly via its Green Prosperity Plan (see our Commentary of May 2024). However, it is doubtful that state-funded investment will be big contributor to a sustained upswing in growth in the near-term. Indeed, the Resolution Foundation notes that the £5bn increase would merely undo one-fifth of the investment cuts due to take place over the next parliament that have been announced by the outgoing government18

Labour market issues

A lack of workers with the appropriate skills is likely to continue to hold back economic growth during the next parliament. The labour market has cooled in recent months and the unemployment rate has risen to 4.4%, its highest since September 202119. However, the number of job vacancies is still around 100,000 above pre-pandemic levels, suggesting an ongoing skills mismatch20. The rise in the inactivity rate (the proportion of people who are neither working nor looking for work), which hit a 9-year high of 22.3 earlier this year, has exacerbated the problem21.

With much of the recent rise in inactivity resulting from both physical and mental ill health, the crisis in the NHS and historically long waiting lists (7.57 million in April22) have been part of the problem. Labour’s pledge to create 40,000 more appointments a week should speed up treatment, and potentially lead to more people re-joining the labour force. However, the plans face considerable barriers (the NHS has its own worker shortage) and are unlikely to yield immediate economic benefits.

A potential quick fix to the shortage of skilled workers would be to increase immigration, but this would be politically difficult. Indeed, the Labour party has recently hardened its stance in this area and has pledged to bring down the number of immigrants coming to the UK. 
Rather than employ workers from overseas, Labour wants to see businesses train British workers. Rising wages and tighter labour market regulation might incentivise companies to upskill their workforce and improve productivity (see our Commentary of April 2024), but this could take years to materialise. In the meantime, a shortage of workers could scupper Labour’s plans to build 1.5 million homes and create 100,000 additional childcare places during the next parliament.

A marginal upswing

Due in part to the pandemic and the war in Ukraine, GDP growth in the UK has been particularly weak in recent years, averaging just 0.9% during 2019-2423. Barring any similar external shocks, growth should pick up during the next parliament. Consumer confidence is improving as real wages turn higher, and a fall in interest rates should support household and business spending.  

The extent to which faster growth results from the policy decisions of a future Labour government is, however, debatable. Assuming divisions within the Labour party (which are bound to come to the fore after the election) do not prove too disruptive, a period of political stability and reduced policy uncertainty could lift private sector investment. However, given fiscal constraints, Labour’s growth plan, which at this stage appears vague, relies heavily on reforms that will face considerable hurdles. Although artificial intelligence could ultimately lead to efficiency gains, poor rates of productivity growth and a shortage of skilled workers will probably continue to stifle the UK economy’s capacity to grow during the next parliament.  

According to independent forecasters surveyed by HM Treasury, real GDP growth is seen averaging 1.4% during the period 2024-2824. Such projections do not appear outlandish, and are slightly above the Bank of England’s 1.0-1.25% estimate of the UK economy’s underlying trend growth rate during the next few years25. Growth in the UK economy can be expected to pick up under a future Labour government, but a return to the 2%-plus growth rates enjoyed during the Blair-Brown years is likely to remain elusive. 

18th June 2024