Rachel Reeves was given a grim reminder of the fragility of the public finances when the UK’s fiscal watchdog admitted on Tuesday that its forecasts — upon which her economic strategy rests — have repeatedly been too optimistic.
On the day the chancellor confronted a £5bn fiscal hole created by the government’s capitulation on welfare reform, the Office for Budget Responsibility said it had regularly underestimated how much the government would borrow over a five-year horizon, while overestimating growth.
The analysis in the OBR’s “forecast evaluation report” included outlooks it has issued since its inception in 2010. Any cuts to OBR forecasts ahead of Reeves’ autumn Budget would add to her mounting fiscal and political woes.
What are the new pressures on Reeves?
Many Labour MPs blame Reeves for the welfare debacle, and now want her to soften her self-proclaimed “iron chancellor” image.
The government’s £5bn welfare U-turn, which averted a massive backbench rebellion, followed Reeves’ grudging decision to rewrite her plan to cut winter fuel payments to pensioners, costing her an additional £1.25bn.
Labour MPs, sensing Reeves’ political weakness, are also pushing for the scrapping of the Conservative-era two-child benefit cap, which would cost the Treasury another £3.4bn. Ministers confirm the issue is on the table and a decision will come in the autumn.
Those policy changes would burn through almost all of the £9.9bn of “headroom” that Reeves allowed herself against her fiscal rules in her Spring Statement in March.
Debt interest costs are not currently acting as a drag on OBR forecasts, unlike earlier this year when they carved a hole in the chancellor’s narrow headroom leading up to the March Spring Statement.
But that position could easily change with market movements and the chancellor remains acutely exposed to forecast downgrades. Government borrowing has on average exceeded the official forecast by 3.1 per cent of GDP on a five-year horizon, the OBR report found.
This reflects both the OBR’s excessive optimism on GDP figures and the legal requirement that the agency bases its projections on government plans, it said.
What else could stretch the fiscal rules?
Efforts to sustain good relations with Donald Trump could also prove costly for the UK.
British officials admit that Canada’s decision to scrap its digital services tax in an effort to smooth trade relations with the US president could lead to renewed pressure on the UK to ditch its equivalent tax, which targets American technology companies.
The digital levy is on track to yield £1.2bn a year for the Treasury by the end of the parliament, according to OBR forecasts.
A further hit could stem from a recent G7 agreement that carves US multinationals out of a top-up corporation tax deal. UK forecasts suggest that tax revenues under the so-called Pillar Two regime will reach £1.5bn a year by the end of the parliament.
“The full details of the Pillar Two solution need to be negotiated with more than 140 countries and any subsequent UK policy changes will be fully costed through the OBR in the normal way,” said a Treasury spokesperson.
Can Reeves find new savings to fill the hole?
The past week at Westminster has shown that Labour MPs are not inclined to support new spending cuts to help Reeves balance the books.
The chancellor has only just completed a tight three-year Spending Review, in which day-to-day spending by government departments will rise by just 1.3 per cent in real terms from 2026 onwards. Some departments face real terms cuts.
Angela Rayner, deputy prime minister, is among those advocating higher taxes on the wealthy rather than cutting services and benefits for ordinary voters.
Will Reeves change her fiscal rules?
A recent Survation poll found that 54 per cent of Labour MPs thought the government “should reform its fiscal rules in order to fund public investment and spending” through higher borrowing.
Anneliese Dodds, former international development minister, has led calls for the rules to be revisited. She resigned in February in protest at cuts to the aid budget, saying “our fiscal rules and approach to taxation” should be looked at again.
Reeves on Tuesday declined to explicitly rule out amending the rules, but noted that she changed them in last year’s Budget to allow more borrowing for investment. The Treasury says the rules are “non-negotiable”.
Cathal Kennedy, senior UK economist at RBC Capital Markets, warned that changing the fiscal rules would damage the chancellor’s credibility with investors and put her job on the line.
“I don’t think the market is in the mood for a fiscal loosening in the UK,” he said. “You saw the reaction to the Budget, and you can see what is happening to the long end of the [yield] curve.”
Are tax rises inevitable?
Yes, according to many economists. Analysts at Capital Economics estimate that the chancellor faces a £13bn-23bn fiscal hole in the Autumn because of the benefit and welfare U-turns and the prospect of OBR forecast downgrades.
Reeves’ problem is that Labour’s manifesto ruled out rises in the three big revenue-raisers: income tax, VAT and employee National Insurance contributions. “We stand by that commitment,” Reeves told MPs on Tuesday.
The Treasury has discussed in the past — but so far not implemented — an extension beyond 2028 of the freeze in income tax allowances and thresholds, which could generate about £8bn a year.
One ally of Reeves said: “You’d end up with hundreds of thousands of pensioners having to fill in tax returns. It would also be very unpopular. But there are no easy options.”
Opting for rises in smaller taxes hold the danger of creating big political problems for little financial gain, as Tory chancellor George Osborne learned in 2012 with his “pasty tax” and Reeves has discovered in her battle with farmers over inheritance tax.
The City of London and the wealthy are obvious targets — but Reeves is acutely aware of the danger of driving businesses and rich people out of the country.
“We aren’t stupid,” said one leading City figure. “There are a bunch of Labour MPs looking for ways to raise more money.”
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