On 26 November, UK Chancellor Rachel Reeves will unveil her much anticipated budget measures to plug the sizeable fiscal hole that has opened up since the spring. At the time of the Spring Statement, the chancellor had left £9.9 billion of fiscal headroom – the amount of money the government has to increase spending or cut taxes before breaking its self-imposed fiscal rules. This buffer has since been eliminated and a shortfall has opened up, with the chancellor now needing to make difficult choices about where to increase taxes and cut spending to restore public finances.

How did we get here?

A combination of higher gilt yields, U-turns on spending cuts and, most importantly, downgrades to the Office for Budget Responsibility’s productivity forecasts are anticipated to have led to a deterioration in the public finances to the tune of £20-£30 billion. If the chancellor chooses to restore a larger fiscal buffer than £9.9 billion, she will need to scrape together even more money.

Options on the table

The chancellor has three choices to plug the gap: increase taxation, cut spending or relax the fiscal rules to allow more borrowing.

The latter looks highly unlikely. Scarred from the Truss episode three years ago, Reeves has reiterated that her fiscal rules are ‘non-negotiable’.

In more recent comments, Chancellor Reeves has suggested that a combination of tax hikes and spending cuts will be required. Given the considerable size of the fiscal hole and political challenges around curtailing spending, the chancellor will have no choice but to lean on taxation at this budget.

Tax increases

One of the most likely policy changes is an extension to the existing freeze on income tax thresholds until April 2030, which could raise just over £10 billion according to the Institute for Fiscal Studies (IFS).

A number of property taxes have been floated, including increasing council tax rates for more expensive properties, closing a stamp duty loophole for commercial properties, and imposing National Insurance on landlord rental income. The risk with the latter is that this pushes up rent inflation, worsening cost of living pressures for tenants.

There are also a number of changes to pension taxation that could be on the cards. Options include lowering the tax-free lump sum from £250k to £100k, which could raise around £2 billion, or reducing income tax relief on pension contributions to a flat 30% rate, raising £3 billion. The problem with the latter, however, is that it would deter individuals from paying into their own personal retirement pot at a time when the population needs to become more self-sufficient and less reliant on an already stretched state.

Changes to Capital Gains Taxation (CGT) could be introduced, as well as a broadening of the National Insurance tax base. A new gambling levy could raise £1.5 billion.

It is clear, however, that if the government chooses to restore a much bigger margin of headroom, it will need to target the big revenue raisers that it ruled out in its 2024 manifesto, namely income tax, corporation tax, national insurance or VAT rates, which in sum are responsible for around 75% of the total tax take.

Of these four, VAT and income taxes raise the most money as they are paid by large swathes of the population. The problem with raising VAT rates, however, is that it would add to inflation and worsen the cost of living pressures that the government has been vocal about tackling. The hike in employer National Insurance Contributions (NICs) at last year’s budget is a case in point of how tax hikes can add to price pressures and hinder the Bank of England’s ability to shore up the economy with rate cuts. Given the government has no fiscal space, monetary easing is one of the few levers that could pull us out of the current economic malaise, and in turn, put government finances on a more solid footing. Recent reports suggest the government is cognisant of this, and is considering removing VAT on household energy bills at a cost of £2.5 billion. While not growth-friendly, increasing income taxes may prove to be the lesser of two evils.

Spending cuts

On the spending side of the ledger, one option is to revisit welfare reform. There have been suggestions that the government will once again try to push through cuts to disability and sickness-related benefit payments that were previously blocked by Labour backbenchers earlier in the year, potentially raising around £5 billion.

The government could also pencil in medium-term departmental spending cuts. Day-to-day departmental spending has been allocated across departments until FY28, but pencilling cuts for FY29-30 could save around £5 billion. There is, however, a risk that unspecified future cuts are not deemed credible from a market perspective.

Let’s not forget the bigger picture

With an economist’s hat on, centring the budget around tax hikes looks likely to depress growth further and, in turn, worsen the fiscal position, resulting in a vicious cycle in which the chancellor may need to implement additional fiscal tightening further down the road. The economy is already at its tax limit, with the tax burden now higher than it has been since the late 1940s.

Focusing on higher taxation also does not get to the root of the problem. While politically challenging, getting spending under control is the only real long-term solution to our fiscal woes. The reality is that we have a smaller share of people paying into the public purse, and an increasing number of people drawing out. In fact, since 2000, we have seen a 44% increase in the number of people over the age of 65, and an 18% increase in the number of people aged 16-64 who are not working due to long-term sickness. Meanwhile, we have seen only a 16% rise in the number of individuals aged 16-64 who are economically active, and thus paying into the government’s coffers.

This problem will only worsen over the coming decades as our demographics deteriorate further. In the year 2000, we had roughly four people of working age for every person of retirement age. Today, there are around three people of working age for each person of retirement age. By 2070, there will only be two people working for each retired person. Maintaining the current magnitude of welfare support will simply not be feasible under successive governments, and an honest conversation with the public around these fiscal realities is needed.

All in all, it is evident that there are no easy choices for the chancellor to make at this year’s budget. What is clear, however, is that repeatedly returning to the electorate with tax hikes will not be a sustainable solution in the long term, and an honest dialogue is needed with the population on the realities of our fiscal situation. Getting spending under control is the only real long-term solution to our fiscal and economic woes.