UK local elections: Labour’s reset problem

Key takeaways

• Weak economic growth remains the central political challenge, limiting the government’s ability to fund priorities without further tax rises or borrowing.
• Any attempt to loosen fiscal rules or pursue more aggressive spending policies could unsettle bond markets and weigh on sterling.
• The next UK government may face increasingly difficult trade-offs between growth, fiscal credibility and electoral support.

After months of speculation about his future, the voters delivered their verdict on the current government at the local elections:  The share of the vote for Labour halved from the general election, it also fell for the Conservatives too, with voters flocking to the two alternative parties, the Greens and in particular Reform. Based on this result, some estimates suggest the Labour party would lose 75% of its current MPs in parliament, perhaps more. With at least two years before you would need to call an election, there is now an urgency for a change of narrative and a change of narrator.

But there is a problem: the advantage of being a Labour leader is that, unless you resign, the chances of being forcibly removed are slim. The last person to succeed was Ramsay MacDonald in 1922. All others have resigned, thereby triggering a leadership content.

Both critics and supporters of the Starmer government agree that the critical issue is a lack of growth. Poor growth has meant that funding the social and welfare changes they wanted to achieve has become impossible, let alone spending on defence, green energy, levelling up or transportation. Poor growth has left voters wishing a “plague on both your houses” and “what have you done for us” as they struggle with rising bills, squeezed living standards and for many higher taxes. It is worth remembering that significant tax increases are already baked in for 2028 and 2029 budgets, to ensure the current government meets its fiscal rules. In a no-growth environment, these tax rises could become a political time bomb.

So, what are the options open to any new leader of the Labour party and thus prime minister? The first option would be to change the fiscal rules. Move the goal posts. Some candidates would ditch them altogether; others would extend them to allow ten rather than five years to get back to neutral; others would exclude defence spending. All three approaches seek to allow more borrowing in order to pump-prime UK growth. The tools proposed to achieve that growth include infrastructure spending, state-owned house building, higher minimum wages, rent controls and nationalisation. Changes to the planning system would remove objections and allow projects to be fast-tracked. If this sounds familiar, it should as much of it has already been proposed but not enacted. Such measures could then be funded through tax rises on unearned income and wealth. The bond markets would be very wary of these approaches, and Sterling would likely fall. This could be positive for the International, high yielding FTSE 100, though.

One striking proposal from the Tribune Group of Labour MPs is to abolish stamp duty and replace it with a tax based on the value of one’s home. Others would tax profits on first homes in line with capital gains tax, while some are suggesting an end to the pension triple lock. All of these policies would disproportionately affect the older voter, who are much more likely to vote but would benefit younger voters who are in work but not yet homeowners. A radical change in the taxation of primary residences could permanently alter buying habits in the UK driving up the rental markets which may well lead to a fall in private house building.

But does any of this accelerate growth in the short term, enough to win an election in one or two years’ time? It would deliver little in 2026, when potentially rising rates, driven by inflation generated by the Iran war, will weigh on all activity.  If the economy still shows no recovery by 2027, then it will embolden the opposition further, even though the position of the Conservatives, with just 120 MPs is hardly strong. Where else could the Labour look for inspiration, for ideas to immediately boost growth under a new leader?

One option would be to emulate the Meloni tax break for home improvements in Italy, which gave a significant boost to growth in the first two years of her premiership – though this carries no obvious social goal. It raises fiscal deficit if not met with tax increases or spending cuts.  In Spain, success in growing the economy since Covid has been built on sharply rising tourism and immigration. Whilst unemployment has fallen, real living standards have been hard to raise, and 70% of new jobs have gone to new migrants. The Labour party is committed to reducing the rate of immigration, not increasing it, and there is a political consensus that the UK could not pull this lever. As for tourism, we do not have the Spanish climate either.

Somehow the UK needs to accelerate investment in projects that can be delivered now – the “oven-ready” ideal of the Johnson years – with a meaningful multiplier effect, whilst also raising productivity and, with it, real wages. How do you do that without increasing fiscal spending or balancing the books. Why do you need to balance the books?

The problem is not the ratio of debt to GDP, nor the size of the fiscal deficit to GDP – both of which are dwarfed by Italy and France – but the cost of servicing that debt as a percentage of government income: In the UK 10% compared to less than 4% in France. Given the view of Global bond investors is that the UK must pay a premium due to past fiscal in-aptitude, the options for reducing the interest bill are limited if you want to spend. A series of deep spending and welfare cuts, reducing growth in the short term but lowering Interest rates in the long term is a policy that the Labour party would never enact.

So, what else, what about getting close to Europe? If the UK were to join the euro, it would get the rates that Greece, France and Italy enjoy.  The only way to do that would be to rejoin the EU – a policy that would be deeply unpopular in the traditional Labour heartlands of the North East and West of England that voted strongly for Brexit. It would cost many MPs their seats.

Whoever is the next prime minister - and it seems possible that we will see a change this year- they will inherit a Gordian fiscal knot of epic proportions. Add to that trying to run a party, deeply split on policy’s as it loses votes to the Greens and reform.  Who would want such a job? No one should ever doubt the ambition of the political class, and because they still have time before the next election, there are more than a handful of credible candidates.

The key takeaway from the May results is that voters have stopped waiting. The window for a reset is narrowing and every option on the table carries a sting in its tail. Borrowing more and taxing wealth will raise uncertainty and has not worked in other countries, notably France who tried it.  Perhaps it’s not a policy reset that is needed but a narrative and a change of narrator.