Blog by Jamie Selig, Political Consultant for the Economy and Financial Services
Background
On 30th October, the Chancellor of the Exchequer, Rachel Reeves, unveiled the inaugural Budget of the new Labour Government. Ahead of the Budget, both the Prime Minister and the Chancellor, said that it was going to be “tough.”
This framing was largely because, following the general election, Reeves unveiled a £22bn “black hole” in the public finances, which she argued neither the Office for Budget Responsibility (OBR) or the Labour Party knew about. She therefore argued that the pressures on the public finances were far worse than she could have imagined.
Striking a more optimistic tone, the Chancellor said that the theme of the Budget was “invest, invest, invest” while also emphasising that this would be a Budget to “fix the foundations.”
Given this framing, how credible is the fiscal position outlined in the Budget? And what is the impact of the Budget’s policies on investment?
Tax and Spend
This Budget increased the size of the state, with the OBR forecasting that spending on the state will settle at 44 per cent of GDP by the end of the decade. This is almost 5 percent higher than before the pandemic and conforms to a post-pandemic trend in the growth of the state.
As has been widely reported, the Budget also contained a significant rise in taxation, with around £40bn a year set to be raised by the end of the forecast, 2029-30. This Budget was the second biggest tax-raising Budget on record and represented the largest increase in taxes at a Budget since 1993. The OBR confirmed that the tax burden would reach “a historic high of 38 percent of GDP” by 2029-30.
Additionally, the Budget contained spending increases of almost £70bn (a little over 2 percent of GDP) a year over the next five years.
The Conservatives have argued that this was a ‘classic’ Labour tax and spend Budget. However, based on recent trends, it may not represent such a departure from past Budgets.
Front Loaded Spending
One notable feature of this Budget is just how heavily the spending is front loaded in the first two years. Day to day, public spending is set to rise by 4.3 percent this year, and by 2.6 percent next year. However, it will rise by just 1.3 percent in the last 3 years of the Parliament, 2026-29.
There are two main views on the motivations for this front loading.
Front loading makes sense if the Government is seeking to address immediate and temporary pressures. She has said that she wanted to use the Budget to deal with the £22bn “black hole” as well as other immediate pressures such as unfunded compensation schemes for the Post Office Horizon Scandal (£1.8bn) and the Infected Blood Scandal (£11.8bn). The Chancellor has stated in dealing with these pressures, she hopes to “wipe the slate clean.” The Government has also allocated £22bn to the NHS to address previously unfunded commitments, such as pay deals and funding for existing deficits, alongside measures to address productivity issues and waiting times.
However, a more cynical interpretation is that this frontloading is really motivated by the need to comply with the fiscal rules. This has prompted inquiries into the fiscal credibility of the Budget. Within the Budget document, the Government have only detailed departmental spending plans for one more year, making it difficult to assess the credibility of their plans.
Fiscal Dark Arts? Or Tight Margins?
This has led to IFS Director, Paul Johnson, essentially accusing the Government of utilising fiscal dark arts.
He has said that the Government has engaged in “silly game playing” by “pencil[ing] in implausibly low spending increases for the future in order to make the fiscal arithmetic balance.”
He continued that “it sounds like it was hard enough to get agreement from departmental ministers to relatively generous settlements in the short term.” This casts doubt on whether the Chancellor and Chief Secretary to the Treasury will be able to balance the books with departmental spending at the 2025 Spring Spending Review.
Johnson’s statement does raise pertinent questions about the Government’s fiscal plans.
Despite a significant increase in taxes, and tight spending plans for 2026, the Government’s forecast headroom is still quite small.
This is further complicated by the inclusion in forecasts of the expiry of the ‘temporary’ 5p cut in fuel duty. Previous governments have included the expiry of this cut in their plans to ensure they meet fiscal rules, but it has yet to be implemented, casting doubt on whether it will be cut as forecast. Including the expiration of the fuel duty cut, the Government has around £10bn in fiscal headroom in the target year, 2029-30. The likely failure to reverse this cut would cost around £5bn, leaving only £5bn in headroom.
The IFS has also estimated that the Government needs around £9bn to avoid real-term cuts to unprotected departments.
On top of this, further pressures are coming. The OBR has revised up its view of likely debt interest payments by about £12bn a year, largely because of higher borrowing, higher inflation and higher interest rates resulting, in part, from decisions taken at the Budget.
In its fiscal and economic outlook, the OBR have said that “the Government has only left itself headroom of £15.7bn against the PSNFL (public sector net financial liabilities) target, which is very low compared to the uncertainties inherent in any fiscal forecast.”
The relatively low amount of headroom means that the Government’s fiscal plans are in some ways at the mercy of external sensitivities and shocks.
This was an issue that the House of Lords Economic Affairs Committee sought to address in their aptly titled report “National debt: it’s time for tough decisions”, which they published prior to the Budget. The committee stated the structure of UK debt had increased the sensitivity of the UK’s debt servicing costs to fluctuations in interest rates, inflation, and shifts in investor sentiment. They recommended that “given today’s geopolitical risks, the Government needs a larger fiscal buffer if it is to be prepared for future economic shocks.”
As the amount of headroom in this Budget is relatively similar to the amount left under former Chancellor Jeremy Hunt’s Spring 2024 Budget, it would be fair to say that the Chancellor did not heed the committee’s advice.
So, given the IFS’ projections, the OBR’s forecast and the Economic Affairs Committee report, it could be expected that some more “tough” decisions on tax and spending may be coming, as the Government may struggle to meet its fiscal rules without raising taxes further.
“Invest, Invest, Invest”
If the Government believe that boosted growth may provide some relief against the fiscal rules, the OBR’s economic and fiscal outlook may provide some further uncertainty.
Both the Prime Minister and the Chancellor have said that the primary mission of the Government is to get Britain growing. They have diagnosed a chronic lack of investment as one of the key drivers of economic stagnation. Therefore, the Government have prescribed increases in both private and public investment to pull Britain out of stagnation.
This Budget comes off the back of the International Investment Summit on 14th October, which the Government said raised £63bn in investment and will create 38,000 jobs. But it also came amidst a backdrop of lower business and investor confidence. For example, the CBI’s Business Confidence Index has fallen to -24, down from -9 in July, and S&P Global flash UK PMI composite output index has slipped to an 11-month low.
The Chancellor has said that she wanted this Budget to crowd public spending towards investment, with one-third of the extra £70bn in spending committed to capital spending. The Chancellor’s new “Investment Rule” has aided this goal and allowed for increased borrowing to fund this investment.
However, according to the OBR, Budget policies will increase UK borrowing by £19.6bn this year and by an average of £32.3bn over the next five years. Much of this will go towards investment, as the “Investment Rule” does not allow for borrowing to fund day-to-day spending. The OBR have said that because of the increase in borrowing and Government investment, they expect there to be some crowding out of business investment. Therefore, they say that “the net impact of policies at this Budget lowers business investment.” This is because the OBR estimated that there is little extra capacity in the economy and as a result, real business investment is expected to fall 0.6 percent as a share of GDP from 2023 to 2029.
Despite the Government’s commitment to increase public investment, the OBR says that the Budget will only provide a “temporary boost” to the economy. Growth is forecast to peak next year at 2 percent, before falling back to around 1.5 percent later in the Parliament. The OBR have also said that the net effect of the Budget “on potential output is broadly neutral by the five-year forecast horizon but becomes positive from the early 2030s.”
Whilst growth is set to be broadly neutral, the Budget does have some inflationary effects. The OBR have said that Budget policies will increase CPI inflation by 0.4 percent in 2025-26 and 0.3 percent in 2026-27. However, annual CPI inflation is expected to remain close to the 2 per cent target throughout the forecast period. The OBR says it does expect a temporary rise, from around 2 percent this year, to an average of 2.6 percent in 2025.
As a result, the OBR have increased their Bank Rate forecast by 0.5 percent on the March 2024 forecast, and 0.25 percent on the pre-measures forecast. This is because the Bank of England would be expected to act to bring inflation back to target over the medium term and be less aggressive in their rate cutting.
On the surface, higher borrowing, higher inflation and crowding out of business investment are not particularly conducive to meeting the Government’s objectives. However, it is true that this Budget is one that takes a longer-term view. Yet, spending is projected to only provide a “temporary boost” to the economy, and the Government has taken a political risk by making investment decisions in which the bulk of the returns will not be felt during this Parliament.
Conclusion
The Budget was an opportunity for the Government to reset the narrative around the economy and investment, in the context of persistent slow growth. Whilst the Government is insistent that the Budget will boost investment, Rain Newton-Smith, CEO of the Confederation of British Industry (CBI), has stated that “this is a tough Budget for business.”
It is clear from the OBR’s report that this Budget does not contain all the answers. But the Government is insistent that it will be successful with its plans to boost investment, and therefore growth. The fruits of the Government’s investments will most likely not be felt during this Parliament, and as such only time will tell if their plans will come to fruition.
The same is true for the fiscal credibility of the Budget. More answers on whether this Budget is purely fiscal tricks, or whether it genuinely attempts to “fix the foundations”, will come at the Spring Spending Review.
The Chancellor will deliver her Mansion House speech today, 14th November, which will provide an opportunity to respond to many of these criticisms. She is expected to outline the next phase of Labour’s plan for Government and provide further proof of the Government’s dedication to boosting both public and private investment. The Chancellor is expected to unveil reforms to the Local Government Pension Scheme, aimed at consolidating them to catalyse investment into the UK economy.