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Rachel Reeves has repeatedly described her commitment to meeting her fiscal rules as “non-negotiable”, but the UK chancellor faces an increasingly onerous task fulfilling that pledge.
Preliminary forecasts from the Office for Budget Responsibility suggest Reeves is in the red against her key fiscal rule because of weak economic growth and higher than expected debt interest payments.
Some of the deterioration is the result of forces largely beyond her control, notably movements in international bond markets.
The fiscal watchdog has also trimmed its growth outlook in its preliminary forecasts, according to people familiar with the matter. Lower growth will hit tax revenue, accounting for part of the worsening fiscal outlook.
But investors warn that Reeves has restricted her room for manoeuvre in the event of adverse fiscal developments since entering 11 Downing Street in July.
How slim is Reeves’ budget ‘headroom’?
In the October Budget, Reeves gave herself extra space to borrow for investment by altering her debt target. But the change was accompanied by a notably tight rule when it came to day-to-day spending.
Under the new regime, Reeves has pledged to bring the current budget — revenues less day-to-day spending — into surplus by 2029-2030. When that fiscal year is three years away, the mandate begins to roll forward on a yearly basis.
Under the OBR’s October forecast, Reeves was on track to meet the target by a margin of only £9.9bn, or 0.3 per cent of GDP. The OBR has pointed out that the figure is the third-lowest amount of “headroom” against the fiscal rules of 28 forecasts made since the watchdog was set up in 2010.
Adverse movements in interest rates or economic growth could quickly wipe away that slender margin in the context of a government that expects to borrow almost £130bn in the current year alone. That is exactly what has happened.
Why are her options limited?
In 2024, Reeves vowed to end the practice of holding two Budgets a year, pledging to create a more stable fiscal playing field as part of her pro-growth mandate.
The shake-up was welcomed by many fiscal experts at the time, owing to the recent history of budgetary volatility epitomised by former Conservative prime minister Liz Truss’s ill-fated “mini” Budget in 2022.
But Reeves left in place rules that require the OBR to publish two fiscal forecasts every financial year. The decision meant she constrained her options when it came to responding to a poor outlook from the watchdog in the spring.
If she announced a tax-rising package in response, it would breach her vow to hold only one big fiscal event a year. This puts the impetus on finding savings in Whitehall departments when the government wants to show it can improve public services.
Reeves has in any event insisted that she does not intend to repeat the kinds of tax rises seen in October, when the Budget lifted the tax take by about £40bn. Before the general election last year, she promised not to raise rates of corporation tax, income tax, VAT or national insurance.
Shortly after the Budget, Reeves told the House of Commons Treasury select committee: “We have now set the envelope for spending for this parliament. We are not going to be coming back with more tax increases or more borrowing. We now need to live within the means we’ve set ourselves.”
What are the escape routes?
Stronger economic growth would undoubtedly help the public finances, but recent surveys and official economic data offer little cause for optimism.
The British economy grew by 0.1 per cent in the quarter to December, the ONS said on Thursday, bucking expectations of a 0.1 per cent contraction.
Yet the OBR is already seen as being overly optimistic about the UK’s growth potential, leaving little scope for extra upgrades. The watchdog has also tended to be highly reluctant to give governments credit for supply-side reforms in its forecasts.
In its latest outlook, the Bank of England downgraded its near-term assessment of the UK’s economic potential. The central bank also slashed its headline growth estimate for 2025 to 0.75 per cent — well below the 2 per cent previously predicted by the OBR. Next year, the BoE expects 1.5 per cent growth, shy of the OBR’s 1.8 per cent forecast in October.
One option would be for the Treasury to tweak the fiscal rules to create more wriggle room, but last month Reeves told the Financial Times she had no intention of making changes to the regime she set in October.
This means prioritising savings in the government’s spending plans. Day-to-day departmental spending is set to grow in real terms by 4.8 per cent this year, 3.1 per cent next year and then by an average of 1.3 per cent afterwards.
Tougher spending limits seem probable in view of the weakening outlook for the public finances, with some of the pain likely to fall in the near term, rather than only at the end of the parliament. Ministers are also considering ways of curbing welfare payments.
But despite Reeves’ vows to avoid fresh tax rises, many investors are warning she cannot afford to take them off the table given the weak state of the public finances.