(Bloomberg) -- Chancellor of the Exchequer Rachel Reeves risks having to fill a fiscal shortfall early next year, running the gauntlet of skittish bond markets in a test potentially tougher than at her first UK budget in October.
The Office for Budget Responsibility, the government’s fiscal watchdog, is expected by some economists to declare that Britain’s finance minister will be breaking her own fiscal rules when it delivers its spring economic update by the end of March. That could force Reeves into an unscheduled mini-budget in a moment of fresh market peril after a rocky reception to her budget.
The prospect of having to announce further spending cuts or tax increases to rectify the government’s economic position would be a blow for Reeves, who has repeatedly said her inaugural budget brought “stability” back to the public finances with a package of more than £40 billion ($51 billion) of tax hikes. Such a move would be in tension with her apparent pledge this week to executives at the Confederation of British Industry’s annual conference that she wouldn’t need further rises in borrowing or taxation.
The potential budgetary woes are the latest danger for Keir Starmer’s administration after a rocky start to Labour’s tenure in power. In her big-tax, big-spending, big-borrowing budget, Reeves left herself just £9.9 billion of headroom against her main fiscal rule of having day-to-day government spending covered by tax receipts. Much of that buffer — already near historic lows — has since been wiped out by higher debt servicing costs.
Several economists, including Citi’s chief UK economist, Ben Nabarro, and Oxford Economics Chief UK Economist Andrew Goodwin, now believe Reeves will need to raise taxes or make savings at the OBR’s next forecast to still meet that rule.
“It really is quite a difficult situation,” Goodwin said. “The combination of wafer-thin headroom and plenty of ways the borrowing forecast could rise means that there’s a good chance that policy will need to be tightened again.”
Factors that could go against Reeves include any modest downgrade to the UK’s economic outlook, further increases in market expectations of long-term interest rates, or spending decisions such as ratcheting defense expenditure up to 2.5% of GDP, as Starmer has repeatedly promised to do.
“It would not take a significant deterioration in the economic outlook to wipe out the chancellor’s headroom,” Ruth Gregory, deputy chief UK economist at Capital Economics, wrote in a note, pointing out that just a 0.5 percentage-point downward revision to the OBR’s 2029-30 nominal GDP growth forecast would be enough. “Economic and market developments could therefore mean the chancellor comes back ‘with more taxes’ much sooner than she would have thought.”
Further complicating Reeves’ challenge are her remarks to the CBI as she fended off attacks from employers and farmers who are furious about the levies announced in October, including a £26 billion increase in national insurance, a payroll tax, on firms.
“You can be confident about the tax rates we’ve set for this Parliament,” Reeves said at the CBI. “I’m not coming back with more borrowing or more taxes.”
The chancellor later appeared to dilute that position when asked if she was ruling out all tax rises, not just those on the business community, telling broadcasters she was “not going to write five years of budgets” now. Starmer used a similar line in the House of Commons, refusing to repeat Reeves’ pledge not to borrow or tax more.
In any event, Reeves’ series of promises have made her a hostage to fortune. Her Charter for Budget Responsibility says the current budget “must be in surplus by 2029-30.” Ruling out changes to taxes — on businesses or otherwise — limits her room for maneuver and echoes the controversial pledge made during the election campaign not to increase big Treasury money-raisers including income tax, corporation tax, national insurance or VAT. Reeves’ critics have said her national insurance increase on employers amounted to a breach of that promise.
The tight fiscal position also puts pressure on Reeves’ vow to only hold one single major fiscal event a year, a move she said would bring more stability and certainty to the public finances.
A person familiar with the matter, who requested anonymity discussing a for-now hypothetical situation, said that Reeves would indeed seek to address any fiscal rule breach if the OBR signals one in the spring, with spending cuts among her range of options. Citi’s Nabarro expects the updated forecasts to show her in deficit by £3 billion to £5 billion.
“The chancellor has repeatedly said she will never play fast and loose with the public finances,” the Treasury said in a statement. “That is why she is committed to one major fiscal event every year to support economic growth and deliver certainty and stability.”
To be sure, market movements could also go in Reeves’ favor such that she continues to meet her rules without needing to change tax or spending. Gregory of Capital Economics said the chancellor could benefit from further and faster cuts to interest rates than currently forecast by the OBR, along with bigger falls in inflation.
But if the numbers move against her, Reeves will have to contend with bond investors who are now more concerned than before the budget, having been taken by surprise by the scale of extra borrowing in October, an additional £142 billion over the parliament. They may punish the chancellor if she tries to fill a new fiscal hole with departmental spending cuts that lack credibility, Citi’s Nabarro said. Tax rises or welfare cuts would be the safest way of plugging any gap to avoid a market backlash that drives up government borrowing costs, he said.
“Something that requires meaningful political pain” would be needed, he said. “Global bond markets are on guard given the fiscal activism of recent years and the UK in particular is under close scrutiny.”
©2024 Bloomberg L.P.