Rachel Reeves’ budget was portrayed as having a growth-oriented approach. But the combination of tax rises and ad-hoc changes to the fiscal rules raise questions over the budget’s ability to meaningfully boost long-run economic growth, argues Dennis Shen.
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UK Chancellor of the Exchequer Rachel Reeves’s strategy for the next five years emphasises economic growth partially funded through progressive policies like tax rises on the well-off. Nevertheless, the plan faced pressure to balance interests among varying stakeholders, from traditional middle-class “Middle England” voters to business and bond markets. The strategy addresses a GBP 22bn deficit that Labour has attributed to the previous government as well as self-imposed fiscal commitments defined during the election campaign that returned Labour to power after 14 years.
The budget marked the seventh adjustment of UK fiscal rules since just 2011 and is focused on balancing the current budget to free up resources for investment. The new target of reducing net financial liabilities by fiscal year (FY) 2029-30, rather than net debt, as a share of gross domestic product underscores the lack of a meaningful straight jacket in the UK fiscal rules, especially in a post-Brexit context absent direct EU fiscal oversight.
The IMF has foreseen a rise of debt under its general government definition to nearly 110 per cent of GDP by 2029.
While the debt reduction timeline was shortened from five to three years, this adjustment only affects the next government and may always be further revised if it were to become inconvenient. The Office for Budget Responsibility (OBR) is projecting a comparatively flat debt trajectory over the forecast horizon based on public sector net financial liabilities. But under the former public sector net definition excluding the Bank of England, the OBR anticipates that debt will rise annually, reaching 95.8 per cent of GDP by FY2029-30, driven by an extra GBP 142bn of borrowing.
The IMF has foreseen a rise of debt under its general government definition to nearly 110 per cent of GDP by 2029. The easing of the budgetary rules and deferral of correcting long-run fiscal imbalances represent specific economic concerns.
The Budget’s impact on inflation and the Bank of England
The budget also presents a challenge for the Bank of England. Increased spending, higher taxes, a 6.7 per cent rise of the minimum wage, and enhancements of workers’ rights are net inflationary. Also, businesses are hiking wages for those paid above the minimum. This has already forced the Bank to consider a more cautious approach around further rate reductions following the 25bp cut last week.
The OBR projects higher inflation by 0.4pps next year and 2026, and inflation averaging 2.6 per cent next year (Figure 1). That is more than 1pp above its March projections. The OBR sees inflation staying above the 2 per cent target until 2029. The more accommodative the Bank of England can be, the more support Reeves receives for the pro-growth agenda, offering more leeway through accommodative capital markets. Conversely, if the Bank is forced to keep rates tight and continue quantitative tightening to address elevated inflation, Labour may face challenging borrowing conditions and closer bond market scrutiny.
With borrowing at near record levels even prior to this significant budgetary loosening, long-run outcomes remain uncertain.
Ten-year gilts rose to around 4.5 per cent in the aftermath of the budget statement, compared against the 4.2 per cent before the general elections. The fact that the spending programme is partially funded likely prevented an even more-outsized market response to date. Markets are concerned by the budgetary expansion that will be financed predominantly by the issuance of long-end securities. Reeves must maintain market confidence especially if the Bank of England’s space for intervention is reduced.
The budget aims to address many priorities such as crucially accelerating output growth and improving public services. Nevertheless, with borrowing at near record levels even prior to this significant budgetary loosening, long-run outcomes remain uncertain.
Meaningful tax rises signal a departure from “New Labour”
Uncertainty around tax hikes had been a drag on economic sentiment ahead of this budget. The tax rises ultimately announced were probably not as broad as many had speculated. A GBP 25bn a year (by 2029) hike of national insurance contributions for employers being the main conduit of revenue raising. The on aggregate GBP 40bn a year of added levies was more than foreseen, although any under-performance of that figure might force further tax rises and/or higher borrowing.
Some of the less-popular reforms earlier contemplated such as holding unchanged income-tax thresholds or hiking of fuel duties and/or suggestions such as more-significant tax rises for private-equity managers and bank windfalls have been ultimately dropped. Addition of a small cut of taxes for draught beers added for buoying popular backing. The strategy of taxing the privileged by capital gains and inheritance taxation, VAT, private-school educations, private jets and secondary homes consistent with bigger government and revenues re-approaching post-war highs.
The trend rate of growth of the UK economy may not be much higher than 1.5 per cent a year. UK growth was nearly double this rate over the decade before the global financial crisis.
The budget commits to GBP 70bn (just above 2 per cent of GDP) of added spending over the coming five years, two-thirds of which goes to current and one-third to capital expenditure. This includes an appropriate substantial investment into the National Health Service. Public spending commitments reverse Tory plans for GBP 19bn of real cuts in FY2028-29, although Reeves requested a moderate GBP 3bn of savings from government departments. Other savings had been announced pre-budget, such as the scrapping of winter fuel payments for most pensioners. Under Conservative plans, capital investment had been predicted to drop to 1.7 per cent of GDP by 2029, but Reeves seeks prudently to keep this at 2.5 per cent for new hospitals, prisons, and roads.
The OBR has forecast that the combined spending and tax programme offers muted medium-run growth dividends, citing “broadly neutral” effects for potential output over a five-year horizon (to the conclusion of the Labour term) and a net boost for the economy not arriving until the 2030s. The trend rate of growth of the UK economy may not be much higher than 1.5 per cent a year. UK growth was nearly double this rate (2.9 per cent on average) over the decade before the global financial crisis.
Figure 1. The OBR’s 2025 projections: optimistic on growth but higher inflation for longer
Annual growth and inflation projections, United Kingdom
Source: OBR (Economic and fiscal outlook October 2024), Bank of England (Monetary Policy Report November 2024), IMF (World Economic Outlook October 2024) and Scope Ratings forecasts.
Many forecasters see the UK growing at just half the pace of the United States over the coming period (Figure 1). If so, such underwhelming near- and medium-term projections may fuel criticism of the government’s performance falling short of Labour’s pre-election commitments of 2.5 per cent annual growth – outpacing the remainder of the G-7.
All articles posted on this blog give the views of the author(s), and not the position of LSE British Politics and Policy, nor of the London School of Economics and Political Science.
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