What will Rachel Reeves’ budget pay for and where will the money come from?
Rachel Reeves’ November budget is fast approaching, and steep tax rises are once again on the cards. Speaking at Labour conference last month, the Chancellor hinted at tax hikes by warning that she will be forced into “harder choices” by “harsh global headwinds”.
To balance the books in accordance with her much-discussed fiscal rules, Reeves will have to commit to between £20bn and £30bn in “fiscal tightening,” according to a report published by Oxford Economics.
The report sets out three potential outcomes of next month’s budget, in which the amount of tightening set out by the Treasury sits variously at £20bn, £25bn, and £30bn. The scale of this balancing act depends on the forecasts set out by the UK’s fiscal watchdog, the Office for Budget Responsibility (OBR), for GDP and tax revenue – among other measures.
Since Labour were elected last year Reeves has committed to a £9.9bn buffer for Treasury spending – known as ‘fiscal headroom’ – but she is facing pressure to use this Budget to carve out more breathing room.
Last week, the OBR indicated that the hole in public finances could reach £30bn, and in July said it had overestimated GDP growth by 0.7 per cent.
While it is the government’s spending commitments which often dominate headlines at the budget, a number of other factors dictate the size of the fiscal hole that the Treasury must plug – including productivity, bond yields, and tax revenue.
‘Unrealistic growth expectations’
Adjusting to lower than expected economic output is likely to account for the majority of fiscal tightening Reeves will have to tackle with the Budget.
According to Oxford Economics, the OBR has significantly undershot its forecasts for GDP growth and productivity, and will adjust these ahead of the Budget.
The watchdog’s economic growth predictions are often more optimistic than other forecasters. The OBR’s latest data states that growth will sit at 1.9 per cent in 2026, while forecasters at Allianz and NatWest both expect below 1 per cent growth.
The OBR had expected the rate of productivity growth to rise from 0.9 to 1.2 per cent year on year by 2027-29, but is now likely to resolve that this will remain at 0.9 per cent.
The potential costs of static productivity were outlined in an Institute for Fiscal Studies (IFS) report last month, which found that Reeves could face an £18bn shortfall by 2028/29 if productivity fails to grow.
But the Oxford Economics report claims that Reeves will have an £18bn hole to fill next month – once the OBR revises both its productivity and its growth forecasts.
The OBR’s forecast for expected GDP in 2029/30 will drop by 0.9 per cent ahead of the Budget, the report claims.
But while the OBR is likely to concede lower productivity expectations this year, a consistent misreading of dwindling productivity will continue into the medium term, according to Daniel Casali, chief investment strategist at Evelyn Partners.
“The OBR has unrealistic growth expectations based on unrealistic productivity expectations,” he told Morning Wire.
Higher bond yields
The rising yield of government bonds is another major consideration for the Treasury.
The government borrows money by selling bonds to investors – these are known as ‘gilts’ due to historically having a gilded edge. The bond yield is the sum that can be exchanged for these bonds, plus any interest payments, until the loan matures.
The cost of gilt yields increases as these bonds become less popular, because investors have less faith in the UK’s economic stability.
British ten-year gilt yields currently sit at 4.7 per cent, compared to 0.2 per cent in 2020. As of last month, the country’s gilt yields were the highest among all G7 countries.
Oxford Economic’s report estimates that rising bond yields will add around £4bn to predicted spending.
Higher welfare spending
The Chancellor will commit to £6bn in spending cuts to cover the costs incurred by the government’s multiple U-turns on welfare, according to Michael Saunders – the report’s author.
This price tag incorporates the costs of the Winter Fuel Payment climbdown, which saw the government commit to handing out the benefit to nine million pensioners. This £6bn will also account for the welfare bill reversal, which a senior minister admitted will bring costs at the budget.
Lower tax revenue
The Treasury may have to account for lower-than-expected tax revenue.
This could require a £5bn-£6bn allowance in the budget, which is reflected in Oxford Economics’ £25bn and £30bn tightening forecasts.
Government tax receipts raised £6.4bn less than anticipated between April and August this year, constituting a 1.4 per cent loss compared to OBR expectations.
Ben Caswell, a senior economist at the National Institute of Economic and Social Research (NIESR), says the Chancellor should build more headroom into the Budget to account for shortfalls in tax revenue.
He told Morning Wire: “Rather than picking and choosing specific taxes and saying that this will raise more or less, the more prudent move would be to simply build bigger headroom into the spending plan.”
More fiscal headroom
The scale of Reeves’ required balancing act could balloon to £30bn if she tries to boost her fiscal headroom from £9.9bn to £15bn.
The Chancellor has been repeatedly criticised for only allowing a £9.9bn margin up to this point. In June, the OECD claimed that this “insufficient” headroom poses risk to the economy.
On Wednesday, leading bond investors Pimco and BlackRock urged Reeves to establish a larger buffer as part of the Budget.
Saunders says the odds of the Chancellor creating a bigger headroom are “50/50”. The measure would “increase the credibility” of Reeves’ fiscal strategy by making tax hikes in further budgets less likely, and could cut up to £5bn from predicted gilt yield costs.
“The big advantage of this would be to raise the chance that Reeves doesn’t have to come back again in the future and do the same thing,” he told Morning Wire.
How will Reeves pay for this?
Reeves will have to rely on major tax hikes for most of the fiscal tightening required at the Budget, according to Oxford Economics.
The Chancellor will likely make spending cuts to account for the £6bn spent in welfare U-turns, but will rely on taxes for the remaining £14bn-£24bn, the report predicts.
Following Reeves’ spending review in June, there is little room for further spending cuts as many departments have had their allowances fixed, Caswell says. Therefore, Reeves may have to rely on taxation.
Reeves has made no secret of the fact that tax rises are very likely, but it is less clear what form these will take.
Think tanks such as the Institute for Government and the Resolution Foundation have urged Labour to break its manifesto commitment not to raise income tax, national insurance or VAT.
“The most likely answer is that one of them will have to go up, and then it’s about choosing the one which is the least damaging economically,” Caswell told Morning Wire.
The Treasury could raise money by extending freezes on thresholds rather than raising the rates of these taxes outright. Oxford Economics estimates that £10bn could be gained from an extension of freezes to income tax and NICs thresholds.
Even if Reeves sticks to her manifesto promises, there remain a range of other fundraising options, including hikes to capital gains tax or “sin” taxes such as alcohol duty.
Other potential tax rises proposed in the report include a windfall on banks (which could raise £5bn), cutting the tax-free lump-sum pension ceiling to £100,000 (£2bn) and extending NICs to Limited Liability Partnerships (£1bn).