(Bloomberg) -- Chancellor of the Exchequer Rachel Reeves will have to increase borrowing by about £25 billion ($32.5 billion) in the budget to bridge the UK’s investment gap, a fiscal expansion that could slow Bank of England interest rate cuts, according to analysis by Bloomberg Economics.
Reeves will also need to raise £32 billion through higher taxes or lower spending to protect all government departments against austerity and give herself £14 billion of headroom in case of an economic shock, Bloomberg Economics economists Ana Andrade and Dan Hanson said in a note published Thursday.
The analysis sets out the challenge facing Labour’s Reeves ahead of her first budget on Oct. 30, as she tries to avoid what Andrade and Hanson called the austerity “embedded” into spending plans inherited from the Conservatives and to stop investment falling as a share of GDP that was also baked into Tory budgeting. The expectation is that the government will both squeeze wealthier Britons and change the fiscal rules to allow more borrowing for investment.
What Bloomberg Economics Says...
“There are three main issues with the fiscal plans Reeves has inherited: they require an immediate cash injection to cover near-term spending pressures, rely on unrealistically tight assumptions for medium-term outlays and see investment fall as a share of the economy in years to come. Together, they add up to a black hole that’s as big as £60 billion.”
—UK economists Ana Andrade and Dan Hanson. Read the full UK INSIGHT on the Terminal.
Just to keep public investment in hospitals, prisons, schools, roads and rail at current levels of around 2.5% of GDP will require an extra £25 billion a year, the economists said. All of that is likely to be borrowed, both stimulating the economy and risking stickier inflation.
Goldman Sachs Group Inc. and Amundi SA are among a number of investors backing UK bonds, in a sign of confidence in the government’s plans.
Meanwhile meeting Labour’s manifesto pledge to end austerity in public services, by ensuring no government department faces real terms spending cuts, will cost £20 billion, Andrade and Hanson said. That would be on top of the £15.5 billion hole in departmental budgets that Reeves unveiled just weeks after Labour won the July 4 election. Other spending pressures add a further £6.25 billion to budgets, the analysis shows.
Reeves is expected to have about £10 billion more headroom than was available in former Conservative Chancellor Jeremy Hunt’s March budget due to forecast changes, which leaves the final savings she needs at £32 billion. The government has suggested that as much as £40 billion may be needed.
Increases in Capital Gains Tax, Inheritance Tax and employers’ National Insurance contributions are expected, which could raise £10 billion to £20 billion, think tanks including the Resolution Foundation and the Institute for Fiscal Studies have said.
According to Andrade and Hanson, Reeves’ balanced current budget fiscal rule — that day-to-day spending must be paid out of taxes — will be the binding one. Definition changes that are expected to her other rule for debt to be falling as a share of national income in five years’ time will make it less restrictive.
“For all the talk of black holes, the overall effect of Reeves budget will be a policy that’s looser, not tighter, relative to the previous government’s plans. That will likely keep the Bank of England cautious about easing swiftly in the months ahead.”
—Andrade and Hanson
Until last month, many investors had expected a fiscally tighter budget but the pressure to bear down on prices has receded, with inflation now below the BOE’s 2% target and signs that the labor market is cooling. According to the analysis, the package of more borrowing and higher taxes will boost the economy, delivering Labour’s promise that the budget will be growth-enhancing despite the “tough decisions” on tax.
An expansionary budget will slow the pace of rate cuts rather than halt them. Sanjay Raja, UK economist at Deutsche Bank, wrote in a separate note the effect would be to “tone down the case for more forceful rate cuts in the near-term.”
The BOE reduced rates for the first time since early 2020 in August, to 5% from 5.25%, and is expected to lower them by a quarter point again in November, just a week after the budget.
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