Rachel Reeves was able to ditch a manifesto-busting plan to raise income tax rates in the Budget because of favourable changes in forecasts from the UK’s fiscal watchdog, government figures said on Friday.
But politics undoubtedly played a big part in the chancellor’s decision to back away from a tax increase that would have provoked deep unease among restive Labour MPs and risked a voter backlash.
With less than two weeks until the fiscal event, a sell-off in government bonds on Friday underscored how rattled the U-turns have left investors.
What has hurt the fiscal outlook?
The Office for Budget Responsibility, which prepares the forecasts used in the Budget, judged in March that Reeves had £9.9bn of headroom against her key fiscal rule.
Government U-turns over the summer on welfare reform and cuts to winter fuel payments for pensions swiftly eroded that buffer by £6.25bn.
A larger blow came from the OBR’s decision to downgrade its productivity forecasts; analysts estimate the move by the watchdog could increase borrowing by between £14bn and £20bn.
Adverse movements in market interest rates could make the hole even bigger, although recent developments could mitigate that damage.
The OBR said on Friday that the market prices underpinning its final pre-measures fiscal forecast were taken from a window of 10 working days up to October 21, when gilt yields were falling.
Analysts at the Resolution Foundation said that could leave Reeves facing a £4bn hit, although other forecasters see less damage.
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Have offsetting factors mitigated the damage?
The watchdog’s outlook had been improved by stronger wage forecasts, according to people familiar with the matter. Michael Saunders, adviser to the consultancy Oxford Economics, estimated that an upgrade to the OBR’s March inflation and wage growth predictions could hand Reeves a revenue boost of up to £9bn.
Firm tax receipts data could also help buoy the outlook, since these figures inform the OBR’s outlook for how much revenue will be generated in the coming five years.
Many other factors would also have played into the OBR’s forecast, and big changes in the run-up to Budgets were “not unusual”, said Paul Johnson, former director of the Institute for Fiscal Studies think-tank. Even “tiny changes” in underlying assumptions could be critical, he added.
The overall deterioration in the public finances that the OBR reported to the chancellor — including the welfare U-turns but before factoring in new policy decisions — was about £20bn, according to people familiar with the situation.
This is less than the £30bn expected earlier in the process leading up to the Budget.
How did the forecast influence the income tax debate?
The OBR’s judgments about the economic backdrop were factored into the final “pre-measures” forecast the OBR handed to the Treasury on October 31.
The watchdog confirmed on Friday that its final forecast would not take account of any economy or public finance data published after that date, although it can factor in later market movements “in exceptional circumstances”.
On Monday, the watchdog delivered its initial “post measures” forecast, costing the chancellor’s planned policy changes. On the same day, Reeves said the Budget would be “difficult” and refused to repeat Labour’s manifesto pledge not to raise income tax.
“I will always do what I think is right for our country — not the politically easy choice,” she told the BBC.
Government figures suggested stronger wage and tax numbers in the OBR outlook helped swing debate inside the Treasury and Number 10 against increasing income tax.
After a week in which Downing Street fuelled speculation that Prime Minister Sir Keir Starmer might face a leadership challenge, officials acknowledged that politics played a part in the decision.
Given improvements in the OBR forecasts there was less need for the extreme decision to breach Labour’s election manifesto, they added.
Responding to the Financial Times’ report that Reeves had ditched the income tax rise, the Treasury said on Friday: “We do not comment on speculation around changes to tax outside of fiscal events.”
Can Reeves win over investors without raising income tax?
Abandoning the income tax increase will not stop Reeves building in extra headroom against her principal current budget rule of balancing day-to-day spending with tax receipts by 2029-30, according to government figures.
Investors expect the chancellor to emerge from the Budget with a buffer of between £15bn and £20bn. This would imply she may still need to raise between £25bn and £30bn in total to offset the fiscal deterioration going into the Budget and build up enough headroom to reassure investors.
“It’s hard to see how you get there without touching the big taxes,” said Ben Zaranko, associate director at the IFS.
Extending the existing freeze on personal tax thresholds from 2028 until 2030 — which now looks set to be Reeves’ single biggest Budget measure — would raise some £8.3bn a year by the end of the decade, IFS estimates show.
Stronger wage growth could mean the policy yields even more, despite the chancellor saying in the October 2024 Budget that an extension would “hurt working people”.
Treasury officials have drawn up a long list of measures that could raise smaller amounts, including higher levies on gambling, a clampdown on salary sacrifice pension schemes and a potential doubling of council tax rates on higher-value properties.
Rob Wood, chief UK economist at consultancy Pantheon Macroeconomics, said he expected “more backloaded and smaller” tax rises, meaning they would help less than expected to bring down inflation in the near term.
Relying heavily on numerous small tax measures was likely to be more damaging to the economy, deterring work, investment and saving, warned Ruth Gregory, an economist at the consultancy Capital Economics.
As with last year’s increase in employers’ national insurance contributions, “Reeves appears to be . . . putting the political optics ahead of reassuring the markets or mitigating the damaging hit to growth”, she said.