Rachel Reeves will need to fill a £22bn hole in the UK public finances at next month’s Budget, according to forecasts from the Institute for Fiscal Studies that increase pressure on the chancellor to raise income tax rather than resorting to a “scrabble bag” of smaller measures.
The think-tank said that without new tax increases or spending cuts, borrowing in 2029-2030 could be about £22bn higher than the Office for Budget Responsibility forecast in March.
A weaker growth outlook, partly due to an expected downgrade in the OBR’s outlook for productivity, together with higher government spending because of inflation, would account for £11bn of this shortfall. The reversal of planned cuts to welfare spending would add a further £6bn and the cost of servicing government debt at higher interest rates could add £5bn.
This would leave Reeves needing to raise at least £12bn through tax rises or spending cuts to meet her main fiscal rule — to run a current budget surplus by 2029-2030 — the IFS said. She would need to raise £22bn to restore the £10bn of “headroom” she had left herself in March.
But Helen Miller, IFS director, said the case was strong for Reeves to build a bigger buffer this time and “do something big enough that you don’t keep getting back into a fiscal groundhog day” of repeatedly tightening policy.
On Wednesday, Reeves gave her strongest indication yet that she was prepared to cut spending as well as raise taxes to fill the fiscal hole.
“Of course, we’re looking at tax and spending as well, but the numbers will always add up with me as chancellor,” she told Sky News.
Increasing fiscal headroom would be all the more important if Reeves’ debt rule — to have public sector net financial liabilities falling as a share of national income by 2029-2030 — became the binding constraint on policy in future years, the IFS said. The think-tank estimates she is on course to miss this target by some £17bn.
The IFS stressed that small changes in assumptions underpinning its figures, which are based on economic forecasts from Barclays, could leave Reeves with a smaller or bigger hole to fill.
Jack Meaning, UK chief economist at Barclays, said a recent rally in gilt prices — if it was reflected in the OBR’s forecasts, which are based on market prices during an undisclosed 10-day window — could reduce the hit from higher borrowing costs by about £2bn.
Miller said that to raise £15bn to £20bn through taxation, “you could do a few smaller things and get there”, but she urged the chancellor to “think properly” first about the design of taxes on property and capital gains, rather than reaching for a “scrabble bag . . . of itty-bitty measures”.
If Reeves wanted to raise “multiple tens of billions”, it would be “hard to see how you can do that” without raising taxes on income or consumption that are paid by more people, she added.
This would not necessarily mean raising the rate of income tax, in breach of Labour’s election manifesto, Miller said. Other options could include looking at the tax treatment of pensions or creating an entirely new tax.
Meaning at Barclays warned that if the chancellor reached for tax increases that added to inflation — for example, an increase to VAT — the hit to GDP could be twice as big as if she chose less damaging options.
Freezing income tax thresholds and raising income tax rates would have a smaller impact on growth, at 0.25 per cent of GDP, he argued.
Moyeen Islam, fixed-income strategist at Barclays, said the composition of fiscal consolidation would be as important as its scale, to win round bond investors who were already being asked to absorb higher gilt issuance.
Spending cuts, or an increase in income tax rates, would be seen as “a critical signal of intent” as they would show the government’s willingness to use political capital to meet its objectives, he said. “The signal is crucial.”
Convincing investors that new spending cuts are deliverable would be difficult, the IFS warned, given the government’s failure to implement its welfare reforms and the fact that it has only just finalised departmental budgets for the next three years.
The findings come as Reeves opened the door for higher taxes on the rich as Treasury officials grow more confident that last year’s raid on non-domiciled taxpayers is bringing in the revenue they have been expecting.
The chancellor has decided against introducing a wealth tax, according to her allies, but she is ready to increase existing levies on richer individuals as she seeks to keep Labour backbenchers onside in what is expected to be a painful Budget on November 26.
Speaking to the Guardian in Washington, Reeves said higher taxes on the wealthy will be “part of the story” in the Budget, dismissing fears of an exodus of high-income individuals from the country as “scaremongering”.
The chancellor announced a further crackdown in October on non-dom taxpayers, building on changes under her Conservative predecessor Jeremy Hunt.
Allies of the chancellor say that, while final estimates are not yet available, “all the indicators” suggest that the tax changes are bringing in the revenue forecast by the Office for Budget Responsibility in October.
Alongside higher taxes the Budget will also contain measures aimed at curbing spending. As part of this, the chancellor has been pushing departments to find new ways of cutting back their spending to “live within their means — that is the responsible thing to do,” said one ally.
The package will also contain measures to crack down on welfare fraud, but it is not expected to contain a major package of reforms such as those introduced and then withdrawn by Sir Keir Starmer’s government earlier this year.
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