Cap energy prices, raise taxes
James Howat, Chief Economist at Labour Together
The conventional wisdom in Whitehall is that we should "wait and see" before doing anything about rising energy prices, and then only help with "targeted measures” for the most vulnerable people.
That is advice for a different world than the one we are in.
Instead, we need to stop energy bills for families and businesses from rising in the first place. Voters are drifting to fringe political parties because of the cost of living. And inflation fears that haunt our financial markets are toxic for Labour’s plans to drive up investment and rebuild public services.
So we need to cap energy prices, funded by a temporary rise in taxes.
Normally, capping prices is a terrible idea. It prevents demand from falling in response to a supply shock. Fortunately, given that prices were high before the war in Iran, everyone already has a big incentive to save on energy.
And it is incredibly expensive. The UK spent nearly £80b on capping prices and other support for households during the last spike in energy prices in 2022/23.
But now, not intervening will be even more costly
If energy prices are sustained at their current level, it could push up inflation by 1 percentage point over the next 12 months. Given that UK inflation and inflation expectations have been above target for nearly 5 years, the Bank of England and financial markets are unlikely to “look through” this surge. Expectations for Bank Rate in 3 years have already increased by 0.4%.
Every one percentage point move in interest rates pushes government borrowing up by £10b. And every percentage point on inflation pushes up the cost of servicing our inflation-linked debt by £5b.
So we need a circuit breaker to stop energy prices from pushing up broader inflation and interest rates.
First, we should temporarily cap energy prices at their pre-Iran war levels. This cap would operate until the government had spent a maximum of £20b on it each year. Based on the gas futures market, that could keep energy prices for households and businesses at their pre-war levels for about a year, and still leave money to knock 10p off fuel duty.
Second, we pay for it with taxes, not borrowing. A temporary 2p increase in the basic and higher rate of income tax would operate for the duration of the cap. This would raise roughly £17 billion if in place for a year. The state of our public finances means we can’t fund this with borrowing - it will push interest rates higher, undoing a big benefit of capping prices.
Third, and hardest, we need to temporarily break the feedback loop between prices and welfare payments. While inflation is above target, we should cap the annual uplift in benefits, pensions, and the minimum wage at the Bank of England’s 2% inflation target. There is form: the Conservatives suspended the triple lock when inflation was high during the pandemic.
Even if we stop energy prices rising, there will be some imported inflation. Breaking these amplification mechanisms will limit its effects. Every percentage point that inflation is above 2 per cent would save the Treasury £3 billion in welfare costs. That should be ploughed back into the benefits system once inflation is back to target so no one is worth off by the end of the Parliament.
For any politician, these are difficult arguments to make. But politically, another round of inflation is much worse. The last few years, and much polling evidence, shows that people care more about price rises than changes in their income.
It is also the progressive thing to do
For the mortgage-paying families who were a key part of Labour’s vote in 2024, the greatest threat is not a temporary tax surcharge, but a sustained rise in interest rates.
And the poorest will benefit more from a freeze in energy prices than lose out from increases in income taxes, of which they pay little.
Keeping interest rates low is also boon to public finances. By weakening some of the inflation amplification mechanisms in our benefits and min wage systems, we can reduce the large inflation risk premium in gilts. That means more money for our public services.
The government has made the cost of living its latest priority. If that’s right, then we need to throw the kitchen sink at breaking the inflationary cycle before it breaks us.
