Labour facing moment of truth over tax pledges, economists warn

Labour is fast approaching a moment of truth over its election pledges on tax and spending, experts have warned, after Rachel Reeves indicated the government could agree above-inflation pay rises for public sector staff.

The chancellor promised a full statement on pay board recommendations that teachers and NHS workers should receive 5.5% pay awards , ahead of an autumn budget that is set to be one of the most difficult economic balancing acts in years.

While Reeves argued that denying such pay rises would bring its own costs, notably in likely strike action and a hit to staff recruitment and retention, economists warned that agreeing them would cost billions of pounds that is not currently on the balance sheet.

Government spending plans, following an election campaign in which Reeves and Keir Starmer repeatedly ruled out rises to many taxes, “aren’t consistent with pay rises in the region of 5.5% to 6%,” said Ben Zaranko, senior research economist at the Institute for Fiscal Studies (IFS).

Related: Reeves hints public sector workers could get above-inflation pay rises

“It’s extremely difficult to see how you do that without finding some extra cash from somewhere, probably some combination of higher taxes or higher borrowing. It may be that they can fudge the fiscal rule or they get a bit lucky with the economic outlook.

“But I’ve got limited sympathy for the argument that things are economically much worse than we thought. It was all entirely predictable – and predicted.”

In a separate sign of the challenge ahead, another thinktank, the Institute for Government (IFG), released a report arguing that such is the state of public services including the NHS, social care, schools and justice system that the promised spending regime is “likely to prove untenable”.

The only apparent way to avoid a further deterioration, it argued, would be radical programmes of reform, boosted capital spending and longer-term budgets.

In her first major interview since becoming chancellor, Reeves insisted that the economy was in a worse state than expected and argued that Rishi Sunak’s government had sat on a series of difficult decisions, saying the teachers’ pay recommendation had been on the desk of the previous education secretary, Gillian Keegan.

While the IFS estimates that a 5.5% pay rise for teachers and NHS staff alone would cost £5.5bn, rising to about £10bn if the same was given to all public sector staff, Reeves indicated she was not unsympathetic to the idea, despite it being well above the current 2% inflation rate.

Ministers would, Reeves told BBC One’s Sunday with Laura Kuenssberg programme, “do it in a proper way – make sure that the sums add up”. She added: “But we also know that there is a cost to not settling – a cost of further industrial action, a cost in terms of the challenge that we face in recruiting retaining doctors and nurses and teachers as well.”

The reaction of public sector unions if ministers rejected pay recommendations would most likely be furious, with the National Education Union , the main teachers’ body, having already warned that strikes “would almost seem inevitable” if this happened.

Any move to balance the books by increasing taxes, even those outside Labour’s election commitments, would be immediately seized on by the Conservatives as breaking a key pledge to voters, as would an increase to borrowing.

Related: Rachel Reeves pledges ‘big bang’ for private pension funds

Speaking to the BBC after Reeves, Jeremy Hunt, the shadow chancellor, said it was “absolute nonsense” to suggest Labour had taken on a financial mess. “This spin about this terrible economic inheritance is because Labour wants to raise taxes,” he said.

Zaranko said that while 5.5% recommendations from pay bodies was “probably above what most people were expecting”, this provided no help with the dilemma of how to keep within stringent tax and spending promises.

One option, he said, could be moves to increase the likes of capital gains tax. “There’s some moderately good economic news out there, it’s possible that they’ll sort of manage to fudge their way through by raising a little bit here, a little bit there,” he said. “But I think that the longer this parliament goes on, the trickier that will be, unless they do manage to magic up some growth.”

In her interview, Reeves also talked up her plan for a review of pensions to make them more flexible and lucrative, as also set out in an opinion piece in the generally Labour-sceptical Mail on Sunday .

“I’m about deeds, not just words, and so we will have that pensions bill and it will do the things that are necessary,” she told the BBC.

The IFG report on public services, released with the public backing of people including Andy Burnham, the Labour mayor of Greater Manchester, warned that under current spending plans, unprotected services, including police, courts and social care, are set for average annual real-terms funding cuts of 2.4% between 2025-26 and 2028-29.

A way out of the quandary, it said, would be to “rethink public service delivery by focusing on prevention rather than acute provision; on capital, rather than day-to-day spending; on frontline innovation, rather than top-down command and control”.

This would, said Nick Davies, the IFG’s programme director, take “political will and bravery” – but that the only apparent alternative was trade-offs over spending and services which would only get worse over time.

Asked about the IFG’s ideas, a government spokesperson said it had “inherited the worst economic circumstances since the second world war”, adding: “The chancellor has asked officials for an update on the fiscal situation and will present this to parliament this month.”