The Week in Politics: Tax, the three-letter word Labour dare not speak

Before Tony Blair left for his month-long summer break, Downing Street asked a handful of sympathetic think tanks for some punchy ideas to be considered for Labour's general election manifesto.

One of them is about to give the Prime Minister some advice that he will not want to hear: the Labour-affiliated Fabian Society will urge him to drop from the manifesto the party's pledge not to raise income tax rates.

It's not the sort of idea Mr Blair had in mind. As this newspaper disclosed this week, he and Gordon Brown intend to repeat the tax promise they first made - with great success - at the 1997 election. The Prime Minister fears that abandoning it would hand some desperately needed ammunition to the Tories, whose cupboard seems pretty bare at the moment.

Taxes have certainly risen since 1997, with the total burden increasing from £114bn to an estimated £205bn. But Labour has blunted the electoral impact by not raising income tax rates, even cutting the basic rate by 1p to 22p in the pound. Stealth taxes may now be reaching their limits, but Mr Blair sees no reason to fuel the Tory campaign about Labour's "third-term tax rises".

Wiser heads in the Government worry that extending the freeze on tax rates will store up big problems and limit Labour's ability to turn round public services.

Mr Blair's approach to tax was forged in 1992, when John Smith's shadow budget, which involved increasing taxes to pay for higher pensions and child benefit, was blamed for the party's election defeat. For Mr Blair, it was a case of "never again". He and Mr Brown have gone further than accomplishing their mission to shed Labour's high-tax image. They have completely closed down any debate on the issue. Tax is a three-letter word that no one in the Labour Party can speak, as Peter Hain discovered last summer when he dared to raise an eyebrow above the parapet.

Although the Leader of the Commons sparked a frenzy of "soak the rich" headlines, what he wanted was a debate about making the tax system fairer rather than a tax hike. But he was stamped on from a great height by Downing Street and the Treasury before he had even made his planned speech and was forced to water it down.

One consequence of Labour's tax straitjacket is that the number of people sucked into the top 40p rate has risen from about 2 million to an estimated 3.5 million since 1997, because the tax band rises in line with inflation rather than earnings.

It would not surprise me if the Tories promised to take many of these middle-income people out of the top tax bracket, and it would be good politics. Expect them to play the tax card at their Bournemouth conference in October.

Labour could trump them by devising a fairer system. For example, Mr Brown could draw up a package involving no overall tax rise, a tax cut for middle-income earners now paying the top rate and a higher 50p top rate on incomes of more than £100,000 a year. It wouldn't raise more money but it would finally end the taboo on tax rates.

It would appeal to the middle-class voters Mr Blair has wooed so assiduously. But it won't happen. Mr Brown wanted a 50p rate in 1997 but was overruled by Mr Blair, who still believes it would send a wrong signal in an increasingly competitive global economy. The Tories would say that Labour was finally reverting to type.

Supporters of a more progressive tax policy do not understand Mr Blair's obsession with 1992. They believe he has forgotten one of his Government's most notable achievements 10 years later, when Mr Brown raised national insurance by 1p in the pound to boost health spending without provoking a public backlash.

The Fabian Society paved the way for this ground-breaking shift by promoting the idea of "earmarked taxes". So it is naturally alarmed that the manifesto will reiterate the pledge not to raise tax rates. "The rise in national insurance in 2002 was the most important social democratic moment in British politics for a generation," says Sunder Katwala, the society's general secretary. "It no longer needs to be taboo to even talk about tax. The 1992 shadow budget was the founding fear of New Labour. It dominates the psychology of No 10 and No 11 and risks setting a limit on what a third term can achieve."

New Labour's neurosis about income tax extends to other taxes. The Government was swift to distance itself from eminently sensible proposals this week by the Institute for Public Policy Research think tank to reform inheritance tax. Again, there would be more middle-class winners than rich losers. But the scheme will probably be deemed too hot to handle and the Government will muddle on with the present - and patently less fair - system.

It is true that Mr Brown has redistributed wealth through his tax credits. But Labour is hemmed in by the pledge on tax rates and, sooner or later, will have to lay to rest the ghosts of 1992 in order to remove distortions from the tax system. Wasn't it Mr Blair who said Labour was "at our best when at our boldest"?