Black holes and consolidations

The upcoming Budget is a make-or-break moment for the Government. After raising taxes and increasing spending significantly last autumn, Rachel Reeves declared that she would not be “back for more”. Yet it seems very clear that this month’s fiscal event will include significant spending cuts and tax rises spurred by a significant deterioration in the public finances. The challenge for the Chancellor, then, is how to improve the mood music around her economic policy agenda while also delivering a tightening in fiscal policy.

The big economic judgement for the Office for Budget Responsibility (OBR) at this Budget will be its revised view of the UK’s ‘trend’ productivity growth – effectively our economic ‘speed limit’ – where a downgrade is widely anticipated. It has been briefed that there will be a 0.3 percentage point downgrade, punching a £20 billion hole in the public finances by 2029-30. A change on this scale would be plausible: it would essentially bring the OBR into line with the Bank of England. And although this change has long been warranted, the timing is out of kilter with the data which, when you measure employment correctly, shows productivity growth at around 2 per cent, the highest sustained rate since the late-2000s financial crisis. It is also possible that the hit to the public finances may be smaller than many expect – more like £14 billion in 2029-30, the year that matters for the fiscal rules – because the impact of any downgrade is likely to be backloaded, only affecting the later years of the forecast. On the other hand, higher government borrowing costs and ‘u-turns’ on Winter Fuel Payments and disability benefit cuts are likely to add a further £12 billion to borrowing.

There is, however, a good chance that other changes to the economic outlook provide some relief for the Chancellor. Chief among these is wage growth. The OBR’s March 2025 forecast for pay increases was very weak, and a stronger outlook for pay could wipe out almost all the hit from lower trend productivity growth. Overall, our modelling suggests that, before any new policy announcements, changes in the economic outlook, as well as those u-turns, are likely to lead to a rise in borrowing of around £14 billion, more than wiping out the £10 billion of headroom against the Chancellor’s ‘current borrowing’ rule at the Spring Statement.

So, although there is much uncertainty about where the fiscal forecasts will ultimately land, these numbers point to a bleak picture for the public finances. Against a backdrop of volatility in the cost of government borrowing, this reinforces the need for the Chancellor not just to fill the fiscal hole, but to take steps to boost financial-market confidence. This means she should aim to double the level of headroom held against her fiscal rules to £20 billion, or, perhaps more realistically, increase it to £15 billion. This would send a clear message to markets that she is serious about fixing the public

finances, which in turn should reduce medium-term borrowing costs and make future fiscal events less fraught.

The Government shouldn’t rule out the possibility of introducing new, targeted policy measures at the Budget. The priority should be to help households struggling with high prices and to support the Government’s laudable targets for reducing poverty. Most obviously, there is no route to bringing down child poverty without scrapping the two-child limit on benefit support, at a cost of £3.5 billion. This should come alongside action on energy prices, which remain the epicentre of the cost of living crisis. The Government should reduce the bits of energy bills it can control directly, moving social and net zero levies on electricity bills into general taxation, costing £3.5 billion in 2029-30. This would cut typical energy bills by £160 a year, bringing down inflation by 0.3 percentage points, as well as reducing the relative price of electricity compared to gas, supporting the move to net zero.

Increasing headroom at the same time as introducing these measures leaves the Chancellor needing to find spending cuts and tax rises of £26-31 billion. To give a sense of the order of magnitude here, if this amount was raised entirely through increases in tax, it would be a similar order of magnitude to the tax rises unveiled by Gordon Brown in 2002 and Rishi Sunak in 2021, but below those in last year’s Autumn Budget and announced by Norman Lamont in 1993.

The Chancellor has been clear that at least part of any consolidation at the Budget will come from lower spending. But the lesson from the Government’s botched attempt to announce benefit cuts in time for the Spring Statement is that such reforms should not be rushed. That leaves lower departmental spending. Given that the Chancellor set department spending totals through to 2029-30 just four months ago in the Spending Review, the scope for cuts here is limited, but freezing departmental spending in real terms in 2029-30 – itself no mean feat – would yield £5 billion of savings.

This would leave the Chancellor needing to raise taxes by £21-26 billion. Any tax changes must, as far as possible, limit the damage to the economy, while reassuring markets that there is a plan if the public finances deteriorate further. They should also fit with the economic circumstances we find ourselves in by avoiding further exacerbating the UK’s inflation problem (our price rises are already the fastest among G7 countries). Instead, the Chancellor should put the burden on those with higher living standards who currently face lower tax rates. This means protecting working people on lower earnings.

Delivering tax rises along these lines, and on the scale required, means prioritising sensible reforms. The best option for reliably raising such sums by 2029-30 is to raise Income Tax (raising VAT, the other broad-based tax, would push up inflation). A 2p

rise across all three rates would raise around £20 billion. However, with wage growth weakening and unemployment rising, the Foundation recommends offsetting this tax rise with a 2p cut in employee National Insurance. That would raise £6 billion overall while protecting most workers from this tax rise. Other measures are almost certainly going to include some form of extension to the freeze in personal tax thresholds, potentially raising £7.5 billion if done for two years. Beyond that, measures should prioritise pro-growth reforms of the tax system, including by improving wealth, motoring and property taxes, and reducing the differences between how we tax employee earnings and other forms of income.

So, although tax rises are inevitable, there is a way to do them which comes with a boost confidence in the economy and the public finances, while also reducing child poverty and the cost of living.