Low growth forecasts, the rising cost of servicing government debt and pressure from higher spending on areas such as the NHS and defence are all contributing to fears that the government’s predicted £9bn of fiscal ‘headroom’ could be wiped out.
The situation looks worse following new projections from the National Institute for Economic and Social Research (NIESR), which suggest a potential shortfall of around £40bn, plus a further £9–10bn needed to restore the government’s previously stated headroom.
Ultimately, the Office for Budget Responsibility (OBR) forecast at the time of the Autumn Budget will be decisive, but whichever estimate is used, the outlook is far from encouraging.
At the centre of the issue is the chancellor’s “stability rule”: a self-imposed target designed to reassure bond markets. The rule requires current expenditure, such as day-to-day spending on public services, to be met from current income, mainly taxation, by the end of a rolling five-year period.
From 2026/27 this becomes a three-year rolling target, which could give the chancellor some additional flexibility.
This year the government is borrowing 3.9% of GDP, effectively borrowing to pay interest
A subsidiary rule also requires Public Sector Net Financial Liabilities (PSNFL) to be falling as a proportion of GDP by the end of the same period. Both rules are heavily dependent on growth: higher growth generates more tax receipts and raises GDP, making the fiscal metrics easier to meet.
To put the challenge in perspective, the UK economy is worth around £3,000bn a year, with a tax-to-GDP ratio of 36.8%, expected to peak at 37.7% in 2027/28. If Rachel Reeves needs to raise an extra £20bn to cover the Budget shortfall – and possibly more – she has three broad options:
- increase the tax-to-GDP ratio by 0.67% (roughly equivalent to two percentage points on all income tax rates, despite manifesto pledges to the contrary);
- hold tax rates steady but rely on 1.8% additional real growth in GDP to deliver the same revenue; or
- some combination of the two.
Politically, growth is the preferable option. But convincing the OBR is another matter.
In March, the OBR forecast growth of 1.0% in 2025, rising to 1.9% in 2026. Independent forecasts are less optimistic, with an average of 1.0% for 2026 and a maximum of 1.5% – well below the OBR’s projection. A 0.9% shortfall in growth equates to a 0.33% fall in tax revenue, or another £10bn to find.
Tony Wickenden: There may be trouble (well, taxation) ahead
Other fiscal targets highlight the importance of growth. Reeves replaced public sector net debt with PSNFL as a target, expressed as a ratio to GDP. Achieving a fall by 2029/30 is easier if GDP grows faster than inflation.
Yet debt interest remains a major burden. With debt at 96.4% of GDP, the net interest bill is projected at £111.2bn in 2025/26 – 3.7% of GDP. This year the government is borrowing 3.9% of GDP, effectively borrowing to pay interest. Unless nominal GDP growth exceeds this level, the debt pile is increasing in real terms.
There is also the catch-22 of raising taxes in a low-growth environment. As shown with increases to employer national insurance contributions, higher tax burdens can themselves weigh on growth prospects. And the interest bill alone dwarfs potential savings from policy U-turns such as winter fuel or disability benefits, which amount to less than 6% of the net interest cost.
All of this leaves the chancellor with little room for manoeuvre in the Autumn Budget. If growth and tax receipts fall short, or spending and debt servicing costs rise further, the headroom could disappear and the fiscal rules be breached.
The interest bill alone dwarfs potential savings from policy U-turns such as winter fuel or disability benefits
That raises the prospect of either spending cuts or tax rises – both constrained by Labour’s manifesto promises not to raise national insurance, income tax or VAT.
The result has been mounting speculation that the government will turn instead to the taxation of wealth and investments. Potential measures include changes to capital gains tax, higher taxes on investment income, reform of inheritance tax, or even the introduction of a wealth tax.
Most recently, reports have focused on a possible tightening of lifetime gifting rules for inheritance tax, though there has been no official confirmation. With the Autumn Budget approaching, conjecture is set to continue until the chancellor sets out her plans on the day.
Tony Wickenden is MD of Technical Connection
