UK Budget: Not so reassuring

In outline terms, this was very much the Budget that most have been expecting for some time despite the messy communications in the run up: Chancellor Rachel Reeves needed to make up a fiscal shortfall in order to meet her fiscal rules.

She has expanded the headroom she has around those fiscal rules and the amount of fiscal tightening she has done is not far off what had been expected in the run up to the Budget. Most of this tightening is being done, as expected, via tax hikes, to the tune of some £23bn by 2029-30.

In the aftermath it will be important to watch how various constituents digest this Budget – including the Chancellor’s own party and the markets.

However, the path is not quite as predicted. Policy changes by the Chancellor raise the deficit through to 2027-28 (i.e. are stimulative) to the amount of £9.9bn by that point, after which there is a sharp tightening. The deficit is £6bn lower than previously forecast by 2029-30. Over the profile, the Chancellor has raised taxes, but also chosen to undertake extra spending.

Taking the Budget as it is, this looks more likely to boost than weigh on activity growth over the Bank of England’s forecast horizon given the near-term net stimulus. However, this Budget is expected by the Office for Budget Responsibility (OBR) to weigh a bit on inflation – albeit only really in 2026-27. That probably makes a December (or failing that, February) Bank of England rate cut a little more likely.

With competing pressures on the Chancellor, it was always going to be challenging to keep everyone happy. In the aftermath it will be important to watch how various constituents digest this Budget – including the Chancellor’s own party and the markets.

Headroom to the fiscal rules remains slim enough and consolidation is reliant on so many moving parts and is backloaded enough that the Budget is not as reassuring as it could have been from a fiscal perspective. The Chancellor also chose to increase spending. That offset part of the tax raise to cover the fiscal shortfall and the (very welcome) increase in fiscal headroom. The OBR put the probability of meeting the current budget rule at (only) 59% despite the increase in headroom. It would not be that much of a surprise to see the Chancellor back next year (or perhaps the year after) asking for more.

The Budget is not as reassuring as it could have been from a fiscal perspective.

Driving the tax increases and fiscal tightening

Changes to forecasts, assumptions and spending plans also fed into yesterday’s plans.  

• The OBR has revised its productivity growth assumption: On its previous forecasts, productivity averaged 1.1% a year, which looked too optimistic against the performance of the last 10 years. The OBR downgraded productivity growth by around 0.3 percentage points a year from 2026 (a touch worse than expected) lowering tax receipts by £16bn a year.
• A mix of other economic forecast changes: These offset the impact of the productivity downgrade, and end up boosting tax receipts by £16bn, including better than expected wage levels.
• In turn, this is more than offset by other factors: The impact of interest rate assumptions, economic changes and disability caseload figures on welfare spending, and a reassessment of special education needs spending help raise the deficit figures before bringing in any policy changes. Accounting for all of these and the economic forecast changes, before building in today’s policy changes, implied a £6bn higher deficit by 2029-30 (£17bn higher in the current fiscal year).
• Increased fiscal buffer: The Chancellor has increased her fiscal buffer against the current budget balance rule from £10bn to £22bn.
• Increased spending: The Chancellor has increased spending, especially over the next three years in a number of areas, though the spending decisions have smaller implications by the end of the forecast horizon (peaking at £10bn in 2027-28 on HMRC costings).
• Compromised fiscal balance: The OBR expects the indirect effects of policy changes to worsen the fiscal picture. 

Economic impact backloaded

The bulk of the tax increases are forecast from 2028-29, i.e. are backloaded, limiting the implications for the economy over the next couple of years. Meanwhile, the additional extra spending is relatively front-loaded. The OBR expects the changes in the Budget today to very modestly raise GDP near-term.

On inflation, the OBR estimates that policy changes including the energy bills package and rail fares freeze, will lower inflation relative to where it would have been otherwise by 0.4 percentage points in 2026-27 (though that includes the perennial fuel duty freeze). Effects are much smaller in other years (including a modest boost to inflation over 2027-29). Minimum wage increases announced this week could support inflation too, however.

Since this Budget likely lowers inflation in the near-term, it somewhat supports the case for further near-term Bank of England rate cuts. However, given that most of the fiscal tightening is backloaded, it may not move the needle much for the Bank at its upcoming meetings.

Plenty of policy change

The Chancellor (as is true for many Chancellors) has chosen to raise tax revenue from a sizeable number of sources and do so in a relatively backloaded way rather than a quick and clean relatively front-loaded tax change that rolled in some tax reform (as for a while was discussed in the press in the build up to the Budget). The biggest measures include:

• Freezing income tax and national insurance contribution thresholds for a further three years (2028-2031), raising just under £8bn on Treasury costings by 2029-30.
• Limiting the value of salary sacrifice tax benefits, raising nearly £5bn in 2029-30.
• “Efficiency savings” of £3.9bn by 2029-30.
• Larger spending measures include removing the two-child benefit cap (HMRC cost this at more than £3bn by 2029-30); not proceeding with the welfare reforms announced in March; accelerating capital investment (temporary boost).

Back for more later?

This Budget was more of a ‘muddle through’ than perhaps markets hoped for at one point and, despite increasing headroom against the fiscal rules, the OBR estimates the probability of meeting the main fiscal rule at only 59%. It wouldn’t be too surprising therefore if we end up seeing yet another round of fiscal tightening in 2026 or 2027. In its report, the OBR also includes a scenario and sensitivity analysis. A 1 percentage point rise in the Retail Price Index (RPI) measure of inflation each year would reduce the current balance (the subject of the main fiscal target) by £10bn and a 0.1 percentage point reduction in nominal GDP growth each year is estimated to lead to an £8bn reduction by 2029-30.

It wouldn’t be too surprising therefore if we end up seeing yet another round of fiscal tightening in 2026 or 2027.

In one piece of simplification though, the government now plans to legislate so that the OBR will only assess performance against the fiscal rules once a year at the Budget. The OBR will still produce a forecast twice a year but, “the government will not normally respond with fiscal policy, unless there is a significant change to the economic outlook that requires a response” (HM Treasury). That should mean that we don’t see the Chancellor making policy changes part way through the fiscal year to keep things on track, potentially lowering at least one trigger for volatility and uncertainty. However, with OBR forecasts still published, that would presumably still let outside observers see how far away the government was from its fiscal target twice a year even if the OBR no longer formally concluded whether or not the government was on track.

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