Spring Statement: Watch out for income tax hikes in the autumn
The Spring Statement has done little to reassure markets about the Chancellor’s commitment to fiscal discipline, says Aviva’s Vasileios Gkionakis
The UK government on Wednesday announced cuts in government spending to rebuild ‘fiscal headroom’ after rising government borrowing costs and anaemic economic growth badly damaged its finances.
Chancellor Rachel Reeves says the mix of cuts in welfare benefits and departmental spending and the indirect effect of higher tax receipts will reduce the government’s total outlays by £14bn by fiscal year 2029/30. That will in turn replenish the so-called headroom to £9.9bn.
The statement was accompanied by news the Office for Budget Responsibility, the UK’s fiscal watchdog, had sliced its 2025 economic growth projection in half to one per cent, although it has increased growth forecasts for subsequent years.
Reeves’s spending cuts come less than five months after her inaugural budget and have essentially been forced upon her by the gilt market, with yields having recently hit their highest level in more than 16 years. Slower growth has also contributed to the worsening outlook for public finances.
Increases in interest rates since October have raised the cost of government borrowing. The OBR expects debt interest spending to total £104.9bn in the current fiscal year. That would represent 8.2 per cent of total public spending and is equivalent to more than 3.7 per cent of national income.
In her October Budget, Reeves had estimated she had £10bn of fiscal headroom but that has been wiped out by rising borrowing costs and a weaker economy. With public sector net debt as a share of economic output at its highest level in more than fifty years, any further rise in bond yields threatens to destabilise the government’s finances.
Although Reeves will see her cuts as necessary, they are causing a backlash from some Labour MPs. This means further welfare cuts would be a very hard sell. The chancellor may have to hike income taxes in this autumn’s budget. Alternatively, she might try to alter her fiscal rules, although this is unlikely, as it would most likely be very badly received by the gilt market.
UK government bond yields declined slightly in the aftermath of Reeves’s remarks, although this had less to do with the contents of her speech than news the debt management office expects to issue slightly fewer bonds in the fiscal year to April 2026 than previously anticipated.
Over optimistic?
If the Chancellor’s assumptions turn out to have been too optimistic, the statement arguably has done little to alleviate market concern as to the strength of the UK’s commitment to fiscal discipline.
Despite these cuts, public sector finances remain in a difficult state, not least given sluggish economic growth. After all, the OBR’s downwardly revised economic growth projections still look slightly optimistic. We believe output is likely to expand by closer to 0.9 per cent.
Importantly growth momentum is very weak and hikes in employer taxes will continue to depress employment growth. It is for this reason the Bank of England is likely to cut rates more aggressively than is currently being priced into UK interest rate markets. While inflation is above target and set to rise further, this is largely due to recent rises in utility bills. They are unlikely to lift inflation expectations materially.
Thereafter, the weakness of the economy should ensure inflation begins falling, which will be enough to enable policymakers to begin turning dovish and cutting interest rates.
Vasileios Gkionakis is senior economist and strategist at Aviva Investors