Then it was high inflation that was the domestic and global challenge, now the problem is low or modest growth, both in the UK and globally. In the mid-70s, of course, the UK had to turn to the IMF for help. That is not going to happen now or anytime soon. But fiscal challenges are likely to be centre-stage in coming years. Indeed, debt levels globally are currently close to all-time highs.
Admittedly the pandemic has played a major part in this, but it is not the only factor. In western economies, ageing populations are adding to upward pressure on budgets. Rising geopolitical tensions are pushing defence spending up. The UK is not immune to these challenges, but as in a number of other major countries the prospect of modest growth adds to the likelihood of debt levels remaining high.
It is against this backdrop that one has to judge Rachel Reeves’s first Budget as Chancellor. Many features of the Budget had been well trailed, although there were some welcome unexpected choices, such as increasing personal tax allowances beyond 2028 and prolonging for one year the five pence cut in fuel duty.
The Budget immediately after an election is often the one in which taxes rise, and this Budget saw the largest increase in taxes since Norman Lamont’s 1993 Budget, although that occurred alongside a sharp fall in interest rates and a sterling devaluation, which boosted growth. The issue now is not only the likely impact on growth of today’s fiscal measures, but also whether there is a mandate for the scale of the tax rises and whether they breach the spirit of the election manifesto.
Addressing high debt
The best approach to reducing high debt is a combination of economic growth, reform of public services, controlling spending, higher taxes or increased borrowing. The independent forecaster, the Office for Budget Responsibility (OBR) is only forecasting modest future growth, after a rebound in the next couple of years. Meanwhile, the Chancellor highlighted some modest reforms, alongside increased departmental budgets now and in next year’s comprehensive spending review.
But this was a tax, spend and borrowing Budget. Each is significantly higher than was the case in the March Budget. There were seventy tax and spending measures in this Budget.
Compared with the March Budget, spending is higher by an average of £83.4 billion each year, until the end of this decade. Of this, £15.2 billion per year was due to pre-Budget measures, and £69 billion was a result of policies announced in the Budget, of which two-thirds goes on current spending and one-third on capital expenditure. That would leave public spending – or the size of the state – at 44.6% of GDP, and 4.9% higher than pre-pandemic in 2019/20.
The Chancellor was keen to differentiate between such higher public investment, which as the OBR factors in, will boost growth over the longer term, and current public spending, which she is trying to cap in future through her fiscal rule of not borrowing for day-to-day spending.
Total public spending this year is £1,335 billion. Higher spending will be funded by a combination of higher taxes and increased borrowing. Taxes are set to rise by an average of £36 billion per year, with the tax take rising from 36.4% of GDP and reaching a “historic high” according to the OBR of 38.2% in 2029/30.
Borrowing, meanwhile, which was already high, rises by £32 billion per year. As expected, the Budget unveiled a change in the definition of debt towards a balance sheet approach – including assets, as well as liabilities. The Chancellor has focused on public sector net financial liabilities (PSNFL), replacing public sector net debt (PSND). Both measures are expected to remain high, with PSNFL only dipping from 83.5% to 83.4% by 2029/30 and PSND falling slightly from 98.4% of GDP this year to 97.1% by 2029/30.
The scale of the net fiscal boost – which is the difference between spending and tax changes – is a large £208 billion over this and the next five fiscal years, up to and including 2029/30.
Modest growth
Despite this, the growth outlook remains modest. The UK is a low growth, low productivity and low wage economy. The trend rate of growth has not rebounded in the wake of the 2008 global financial crisis. The OBR is forecasting growth of 1.1% this year, which is in line with the consensus, rising to 2% next, before slowing to 1.8% in 2026 and then stabilising around 1.5%.
Given the scale of the fiscal boost it is significant that the OBR is not expecting the rebound in growth to be sustained during this decade. In part, it is because they are more cautious about inflation returning to the 2% target and also because they appear wary about the extent to which policy measures in the Budget will impact the wider economy, dampening growth.
Interestingly, and indicative of the difficult economic outlook, the OBR sees real household disposable income rising by 2.4% this year and 2.1% next but then increasing by only 0.6% in 2026 and 0.2% in 2027. It then picks up modestly in following years, against a backdrop of sluggish wage growth and with the savings ratio falling from 11.5% in 2024 to 8.1% by 2029.
The Chancellor cited investment as the key to deliver higher growth. Indeed, low UK investment has been a longstanding problem, as I have been saying for decades. The focus of the Budget was on boosting public sector investment. I welcome this, including the focus on infrastructure, the green agenda and on improving the supply side of the economy, helped by previously announced aims to ease planning reform.
The benefits of higher public investment and its multiple effects, however, are long-term but immediately it increases the already high amount of borrowing. This, of course, is not without its challenges, as the government does not have a good track record of investing well, plus as HS2 shows, infrastructure costs can quickly run out of control.
Moreover, in a mature economy like the UK, the highest returns may be achieved in maintaining the existing capital stock, which counts as current spending, or in smaller projects. Investment in a public asset also often necessitates higher associated current spending. Regardless, addressing the UK’s low rate of investment should also include incentivising the private sector through targeted fiscal policies and encouraging the City to close funding gaps, such as the lack of patient capital and finance to small firms.
The challenge is the burden that policy changes will impose on the private sector. Higher taxes were focused on higher employers’ national insurance contributions (NICs), which will add to employment costs and hit small firms (the 223,000 firms with 10 to 249 employees), and micro-firms (the 1.18 million firms with 1-9 staff) and potentially dampen growth prospects.
The OBR assumes that by the end of the decade, one third of the expected tax take from higher NICs (of £25.7 billion) will be reduced by behavioural changes, the bulk of which will be firms passing this on by squeezing wages and salaries. While the rise in the minimum wage is understandable, given the cost-of-living crisis, concern has been raised about the impact this, too, may have on small firms.
Other areas to be hit by higher taxes included inheritance tax and capital gains, and indeed the fear of these had already led many to review their personal finances ahead of the Budget. There were changes on housing, too, including strangely a reduction in the rate of stamp relief for first time buyers.
Incentives matter, as does confidence, for growth. Such a policy outlook of higher taxes may act as a dampener on growth.
Market reaction
It is little wonder, therefore, that the gilts markets reacted a little nervously immediately after the Budget, although it stabilised with yields slightly higher than before the speech. The Debt Management’s Office updated Financing Remit pointed to additional gilt sales of £19.2 billion in 2024-25 to £296.9 billion, and an increase in Treasury Bill sales by £3 billion. Sterling, and equites, too, were relatively stable. Although it can sometimes take time for the full details of the Budget to emerge, the immediate market reaction was that the economic and fiscal numbers are credible, but worrying.
These numbers will add to worries about yields and dampen expectations about how far policy rates can fall.
From an economic and financial markets perspective it was felt that whoever won the election would need to address the poor fiscal position, and the high level of debt. Boosting public investment, funded by higher taxes and borrowing, has been the focus. Unless growth moves materially higher, addressing the overhang of debt remains the key future challenge.
The markets, though, will take relief from the outlook for interest rates. While interest rates still look set to fall from their current 5% level, the economic outlook of a near-term bounce in growth and of some future stubbornness in inflation may point to rates settling at a higher level than pre-pandemic, around 4% or possibly 3.5%.
Please note, the value of your investments can go down as well as up.
