Budget 2025: Financial experts reveal whether increasing income tax or VAT will have ‘least damaging’ impact on economy
The government faces pressure to raise revenues as Chancellor Rachel Reeves prepares to announce her autumn budget.
Economic analysis published in October suggests that increasing income tax would be the “least damaging” option for the Chancellor to the economy compared to increasing VAT.
The National Institute of Economic and Social Research (NIESR) found that increasing VAT would affect real incomes more, while increasing income tax would be less harmful.
The think tank, which analyzes income tax, corporation tax and VAT, also warned against raising revenue beyond these “core” UK taxes, considering other methods to be potentially harmful.
Of the three, NIESR said increasing VAT would have the biggest negative impact on the UK economy, reducing real personal disposable income (RPDI) by around 3 per cent and real gross domestic product (GDP) by around 1 per cent in the first year of the tax.
A higher VAT rate will increase inflation more than other levers due to the impact it will have on prices in stores.
According to the analysis, increasing the corporate tax on profits made by businesses will have a smaller impact in the short term, but will negatively affect the economy by reducing investments in the long term.
Raising the income tax, on the other hand, would have the lowest impact, reducing GDP by about 0.05 percent in the first year after the tax is implemented.
The scenarios in NIESR’s analysis are based on the assumption that the government aims to increase total net annual income by £30bn by 2029-30.
That’s the amount Ms. Reeves needs to raise to fill the predicted black hole in the public finances.
The “least worst” option for the Chancellor is therefore to increase income tax in his next Budget, NIESR said.
The think tank acknowledged that this would mean the Labor government would break its manifesto commitment not to increase taxes on “working people”; He said this was now widely interpreted to mean income tax, VAT, employees’ national insurance contributions and corporation tax.
“We argue that they could find other ways to raise tax revenue, but doing so would be far more disruptive and would harm the economy in the long run,” the report’s authors wrote.
Ed Cornforth, NIESR economist and main author of the analysis, said: “Our analysis clearly shows that an increase in income tax is the Chancellor’s least damaging, safest option to put the economy on a sustainable, secure footing.
“VAT, an undesirable option given current inflation expectations, would put pressure on prices and additional business taxes would undermine investment incentives at a time when employer NICs are already weakening business confidence.
“While politically unpalatable, avoiding increasing income tax will force the Chancellor into worse options; tinkering around the edges will not shift the dial.”
