Rachel Reeves is aiming to create more “headroom” against her fiscal rules in November’s tax-raising budget, to cushion the UK against volatile government bond markets.
The chancellor met her first rule – to balance taxes and day-to-day spending – with £10bn to spare in last autumn’s budget, and again at her March spring statement.
That historically narrow margin has repeatedly left Reeves at risk of breaching her rules, amid market pressures pushing up the cost of government borrowing.
The chancellor hopes that by accumulating more headroom, she can dampen incessant speculation about whether the rules will be broken in the Office for Budget Responsibility (OBR)’s next forecast – and how the government will respond.
“We would like more headroom. We want to try to insulate ourselves better against the volatility in the bond markets,” said a Treasury source, adding that tax increases and spending cuts were on the table.
However, with Labour trailing Reform in the polls, ministers are acutely conscious that after last year’s £40bn-a-year tax-raising package, another money-raising budget will be a hard sell with voters.
“The chancellor is right to try and increase the margin for error against the fiscal rules,” said Ruth Curtice, the director of the Resolution Foundation thinktank. “Doing so could have big rewards, not least in reducing the chances of having to come back for a third round of tax rises next year.”
She added: “With typical variation in forecasts of £17bn, a margin for error of under £10bn in a time of heightened global uncertainty was always slim. But increasing that margin will require even tougher choices in an already daunting budget. That’s easier said than done.”
A downgrade in the OBR’s forecasts for productivity, leading to a weaker outlook for economic growth, is already expected to have blown Reeves £10bn-£20bn a year off course since the spring statement.
There is a further £6bn-a-year gap from the cost of reversing the cuts to winter fuel allowance, and the welfare changes rejected by Labour backbenchers. Any increase in headroom would have to come on top of that.
Reeves has rejected calls from some in her party to breach Labour’s manifesto pledges on the main rates of income tax, national insurance and VAT, however – taxes that account for about 75% of government revenue.
Instead she is drawing up a package of tax-raising policies that, she will argue, iron out distortions in the system. Measures under consideration are believed to include charging national insurance on landlords’ rental income; further reforms to capital gains tax; and an increase in taxes on gambling, as advocated by the former chancellor and PM Gordon Brown.
The budget was also expected to “face into” longer-term pressures on tax and spend, Treasury sources said.
The OBR recently argued the public finances were unsustainable in the long term, highlighting the rocketing cost of the pensions triple lock, and plunging revenues from petrol tax as drivers switch to electric vehicles.
Labour has promised to maintain the triple lock for the duration of this parliament, and recently excluded it from the remit of the independent pensions commission, but has made no commitment beyond the next general election.
The Treasury hopes a decisive package of tax and spending measures in the budget will increase bond investors’ confidence, potentially lowering borrowing costs.
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The former Conservative chief secretary to the Treasury David Gauke said Reeves could win over bond investors by building up much larger headroom, of perhaps £20bn-£30bn – but warned it would be very difficult politically.
“This is still early in the parliament. If you can successfully land it, then you do find yourself in a virtuous circle with the markets,” he said. However, given the scale of tax increases required, he added: “It would be a big leap into an icy pool of water and you don’t know if you’re going to be out of your depth.”
The government now spends £110bn a year on interest costs alone, so even modest market moves can come at a significant price.
The putative Labour leadership contender Andy Burnham complained recently that the party’s policies had been too much “in hock to the bond markets” – a comment ridiculed by Reeves and her allies.
Yields on 10-year UK government bonds, or gilts, which move in the opposite direction to prices, have risen from 4.2% to 4.7% since Labour came to power.
Treasury sources blame global instability, pointing out that with government debt markets tending to move together, yields jumped on Monday, as the French budget crisis caused market instability, for example.
But analysts also blame the state of the UK’s public finances, given weak growth and mounting spending pressures.
Helen Miller, the director of the Institute for Fiscal Studies, said: “Adjusting policy twice a year in response to run-of-the-mill forecast changes is not a sensible place to be in. The problem is not caused by the OBR, or by the number of fiscal forecasts, but by the chancellor’s decision to operate with tiny headroom against pass-fail fiscal rules. A clear way to break out of this cycle would be to use the upcoming budget to build a larger amount of fiscal headroom.”
Andrew Goodwin, the chief UK economist at the consultancy Oxford Economics, said: “Markets are concerned about the fragility of the UK fiscal outlook.” He added: “With markets effectively giving the UK the benefit of the doubt, sentiment could turn rapidly, particularly if the government missteps.”
