Chancellor’s budget faces challenge amid tax hikes

Warnings of a “painful” Budget signal that significant tax increases may be on the horizon as Chancellor Rachel Reeves aims to address a £22 billion “black hole” in the public finances.

bhile she promises to end austerity and increase spending on essential services like hospitals and roads, which are vital for economic growth, the question remains: how will she achieve this without imposing heavy tax hikes?

Reeves is expected to unveil a strategy centered around the government’s self-imposed borrowing limits. While this approach may not eliminate tax increases altogether, it could help mitigate their magnitude.

The UK government has committed to maintaining its fiscal rule that mandates national debt must decrease within five years. Most wealthy nations follow similar rules to maintain credibility with financial markets and taxpayers, which is crucial as the UK has operated at a deficit in nine out of ten years, often relying on borrowing to cover the gap. A loss of credibility in these rules can lead to increased borrowing costs, as demonstrated by Liz Truss’s 2022 mini-Budget, which resulted in soaring borrowing costs due to a lack of credible plans to fund substantial tax cuts.

In her upcoming Budget, Reeves will set her own fiscal rules, but the independent Office for Budget Responsibility (OBR) will evaluate their impact on public finances. Ahead of the general election, she plans to largely mirror the rules established by her predecessor, Jeremy Hunt. When Hunt presented his Budget in March, the OBR indicated that he would meet the fiscal rules with minimal surplus.

To navigate this fiscal squeeze, Reeves may redefine what constitutes debt. For instance, she could adjust how the Bank of England’s operations are accounted for, particularly regarding losses incurred from selling long-term bonds it purchased during the pandemic. A redefined measure of debt that accounts for these losses differently could portray a more favorable picture, allowing her to assert that debt is declining faster than currently projected and providing an additional £16 billion for spending.

Alternatively, Reeves might opt for a broader approach to public finances that emphasizes the value of government assets rather than merely tracking inflows and outflows. This could involve considering public sector net financial liabilities, which includes future student loan repayments and could yield an additional £50 billion. An even broader measure, public sector net worth, takes into account the value of infrastructure assets, but is more complex to calculate.

However, there are pros and cons to these various debt measures, and the most favorable metric today may not be the same next year. While economists are generally accepting of which measure Reeves chooses, concerns linger about the implications for borrowing costs. Currently, £1 of every £12 the government spends goes toward interest payments on existing debt. With expectations of increased borrowing from financial markets, new borrowing costs are already rising, affecting fixed-rate mortgage deals. Nevertheless, analysts suggest that these increases may be limited, as there remains a strong appetite among investors for government bonds.

Reeves has emphasized that she will not exhaust all available funds, asserting that credibility depends on prudent spending. She has stated she is not in a “race to get money out of the door.” The majority of any additional funding derived from adjusting the rules will likely be allocated to investment projects, such as infrastructure development in schools and roads. Reeves has committed to a crucial second rule: that the government will cover all day-to-day expenditures with tax receipts.

To address declining investment spending relative to economic size, an estimated additional £20 billion is needed. In a bid to maintain market confidence, Reeves has promised to limit the pace and extent of new investment spending. However, this creates a significant challenge, as many public services are facing tight budgets for operational expenses. Addressing these pressures while fulfilling other manifesto commitments could necessitate tax increases of up to £25 billion, according to the Institute for Fiscal Studies. While the Labour government aims to raise £9 billion from its manifesto proposals, details on the remaining measures are still forthcoming. As October 30 approaches, the public will be watching closely to see which groups emerge as winners and losers from Reeves’s fiscal decisions.