Budget choices and challenges facing the new UK chancellor

Having ridden a tide of optimism in the initial weeks after the election, the UK’s new Labour government has recently changed to a more sombre tune, making clear that tough choices lie ahead. Indeed, Prime Minister Keir Starmer himself has warned that it will be “painful”. On 30 October, when new chancellor, Rachel Reeves, presents her first budget, we will find out quite how painful, and for whom.

There are a number of challenges that she faces and narratives that need to be reconciled.

1) UK government departmental spending

On the spending side, the chancellor will need to decide what to do about the projections for day-to-day departmental spending.

The plans that Labour inherited from previous Conservative chancellors were very tight, with the 1% annual increase in real terms felt unevenly across government departments. Current spending plans suggest a particularly acute squeeze on the so-called ‘unprotected’ government departments; those outside of the NHS, defence, schools, overseas aid and childcare. Such spending restraint does not fit with the narrative of Starmer’s statement that “there will be no return to austerity”.

Raising spending so that each department is at least flat in real terms through to 2028-29 would require an additional £10bn-£20bn. In addition to this challenge is the £22bn ‘black hole’ for the current fiscal year that Reeves has recently been highlighting. This partly reflects unfunded commitments by the previous government on asylum support, Ukraine aid and transport maintenance. It also reflects the 5.5% public sector pay rises that have already been awarded to teachers and NHS staff for 2024-25. The government has since announced a number of measures to close the fiscal gap, including ending automatic winter fuel payments to pensioners, but a sizeable shortfall remains.

2) Navigating capital spending

The current projections also include a 33% cut to the level of public sector investment in real terms over the next five years. Reeves has said that this will be a “budget for investment” so one would think she would want to boost spending here, though even just bringing investment spending to flat in real terms requires £18bn over the next five years.

3) Tax strategies

How to pay for this increased spending is the challenge. At an aggregate level, there isn’t any obvious low-hanging fruit. The tax take in the UK is already at its highest level since 1949 and having won the election with a relatively small share of the popular vote, Labour will be cognisant that unpopular choices could hurt its re-election prospects in five years’ time.

In addition, Labour’s pre-election promises ruled out raising the rates on all the big revenue raising taxes – income, national insurance, VAT and corporation tax – which together make up almost 75% of the UK total tax take. Although changing the rates would be seen to be breaking the manifesto pledge, the government could potentially change the thresholds.

This leaves the smaller taxes where the levers have to be applied more heavily to generate meaningful revenue. Analysis from the UK’s Institute for Fiscal Studies shows the range of options currently being discussed and the revenue up for grabs with each change:

Wealth taxes are an area where we could see change. Options include changes to capital gains tax thresholds and rates, less generous income tax treatment of pensions, and changing inheritance tax.

We could also see changes to property taxation through changing council tax bands and/or rates. The problem with this is that the benefits accrue to local government rather than the Treasury and it is often seen as a tax on London and the South-East which tends to have higher property valuations.

4) Growth agenda

Overlaying these budget considerations is the constraint that tax and spending decisions need to be consistent with the growth focus that was at the heart of Labour’s campaign. Spending more, particularly on investment, clearly fits with a growth agenda. Raising taxes would be harder to align.

Taxing wealth and higher earners and redistributing towards lower income cohorts might be net growth positive given lower income households have a higher propensity to consume.

But there could be significant unintended consequences. Any taxes that deter savings and investment, particularly for pensions, will only worsen the long-term problem of how the UK will fund its ageing population.

Stepping away from the minutiae, ultimately, the UK’s real fiscal challenge lies in the stark demographic changes set to play out over the coming decades. The proportion of people ‘paying in’ to the public purse will be falling as the proportion ‘drawing out’ will increase significantly. The UK’s current ‘pay as you go’ public pension system will prove woefully inadequate, so individuals need to be incentivised to plan and save for their own retirement.

Increased tax rates on the wealthiest individuals could also prove damaging if high earners, who tend to be highly mobile, chose to relocate to other more tax favourable geographies. It is sometimes the case that beyond a certain point, as tax rates rise, tax take falls, and vice versa (known in economics as the Laffer curve).

We have seen this before. Data from HMRC shows that former chancellor George Osborne’s decision in 2012 to cut the top rate of income tax from 50% to 45% saw an £8bn increase in revenue from additional rate taxpayers in 2013-2014.

5) Pleasing the electorate or pleasing the bond market?

The chancellor could choose to avoid difficult tax decisions by borrowing the additional money required. In theory, the government has fiscal rules that would limit its ability to do so, but in the world of UK fiscal policy, rules are made to be broken.

The current fiscal rules state that public debt should be falling – relative to the size of the UK economy – between the fourth and fifth year of the forecast period.

Extending the target date by which debt is supposed to be falling would provide a little space. There is also the potential for some creative accounting that could change how the Treasury handles cashflows to and from the Bank of England.

A more drastic, but riskier option, is to change the focus from net government debt to net wealth, in order to capture a broader measure of both public sector liabilities and assets. This sounds sensible in theory. If the government is spending on infrastructure to enhance the nation’s capital stock and wealth, this should generate future output and tax receipts and ultimately pay for itself. Having a fiscal rule that does not constrain them from such growth-enhancing investment seems sensible.

The devil, however, is in the detail. Are the projects truly generating wealth? Who judges how much wealth is being created? Is a new railway system wealth? A hospital? A teacher? All could arguably raise the future productivity of the nation. The independent Office for Budget Responsibility could add some credibility to such an assessment but it may raise concerns among bond investors if such a change to the rules is not seen to be a sufficiently binding constraint.

Conclusion

The UK has a new chancellor, but ultimately the same problems. An ageing population in an economy with weak productivity and nominal growth makes for very difficult fiscal decisions. We suspect the chancellor will aim to muddle through at this budget, with a bit more spending, a few minor tax changes and a bit more borrowing. Hopefully, 2025 will see some of the non-fiscal policies, such as planning and regulatory reform, bear fruit and coincide with a stronger global cyclical upswing, easing the fiscal challenges.

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