Analysis from Raphael Olszyna-Marzys, international economist at J. Safra Sarasin Sustainable Asset Management
Chancellor Rachel Reeves will unveil the government’s new budget on November 26. Further fiscal consolidation is all but certain; the question is by how much. Judging by a recent commentary, the Chancellor appears keenly aware that disappointing financial markets would backfire. She must set out a credible plan and a clear path ahead. Another challenge is how to do so – balancing the need for fiscal discipline with the imperative not to choke off growth. Most of the adjustment is expected to come through higher taxes.
The UK gilt market is vulnerable
Ms Reeves insists that the government’s fiscal rule is ‘iron-clad’ – and with good reason. Without further deficit reduction, Britain’s public debt will remain on an unsustainable path. The country is particularly exposed given that around a third of its debt is held by foreign investors. The Chancellor has not forgotten the turmoil that followed the attempt of PM Truss and her Chancellor Kwarteng to revive growth through unfunded tax cuts.
The Chancellor was just on track to meet fiscal rule
The current rule is to balance day-to-day spending and revenues – i.e., excluding capital investment – by 2029-30, the fourth year of the forecast horizon. In March, the Office for Budget Responsibility (OBR), the fiscal watchdog, projected that the deficit would fall from £60.7bn, 2.1% of GDP, in 2024-25 to £36.1bn in 2025-26 and £13.4bn in 2026-27, and turn to small surpluses thereafter. The Chancellor’s decisions in the Spring Statement left her with roughly £10bn of ‘headroom’, 0.3% of GDP, by the end of the period, restoring the fiscal space she had lost since the previous October Budget.
Government has borrowed more than expected
But since then, and once again, government borrowing has run above the OBR’s projections, for three main reasons. Firstly, spending U-turns; the reversal of the planned welfare cuts has cost around £4.8bn, and reinstating winter fuel payments adds another £1bn. Secondly, higher borrowing costs; gilt yields have risen sharply since last autumn, lifting debt-servicing costs. Thirdly, weaker revenues; tax receipts have fallen short of expectations.
Lower OBR long-term productivity growth forecasts
To make matters worse, the OBR is expected to trim its long-term productivity-growth assumption. At 1.3%, it looks very optimistic compared to almost all other forecasters. Even a modest downward revision of 0.2-0.3 percentage points would have a significant impact since every 0.1ppt cut reduces fiscal space by £9-10bn.
Government needs to deliver further fiscal tightening
Taken together, this could leave the government to find an extra £20-30bn more a year by 2029-30 to meet its fiscal rule and rebuild some buffer. So, closing that gap would require additional policy tightening, spread over the next few years, of at least 1% of GDP.
Timing is difficult given elevated downside risks to growth
The timing for further consolidation is not ideal. Risks to growth and the labour market appear skewed to the downside. The Bank of England (BoE) sees a one-in-four chance that GDP will contract in the final quarter of 2026, and it still judges unemployment risks to be tilted upwards, even after the steady increase of the recent months.
Tax hikes are preferable
Fiscal tightening must thus be designed in a way that minimises the near-term drag on growth. That argues for tax increases rather than spending cuts to welfare or investment, which tend to have higher multipliers – and are politically fraught in any case. Ideally, Ms Reeves would seize the moment to simplify the tax code, improving efficiency and encouraging investment. More likely, however, the budget will feature a patchwork of modest revenue-raisers: higher gambling and other ‘sin’ taxes, tweaks to income-tax bands, and perhaps a levy on the income that banks earn from reserves held at the BoE – the so-called QE-reserves tax. Together, such measures might just be enough to satisfy the fiscal rule, though more contentious options, such as changes to inheritance tax, can-not be ruled out.
A tighter Budget gives scope to cut rates further
Ultimately, the government must not only convince bond investors that its finances are sound but also lay the groundwork for stronger growth. Accelerating its supply-side reforms agenda would help. In the meantime, tighter fiscal policy should give the BoE scope to cut interest rates a bit more than markets expect – offering at least some relief for both borrowers and the Treasury’s balance sheet.
