UK Budget preview: Reeves prepares sweeping tax rises as fiscal squeeze deepens

Reeves, however, seems unwilling to wait that long before making public remarks, given her decision to hold a pre-Budget press conference in Downing Street today. While such a press conference may not be unprecedented, I certainly cannot remember a time when a Chancellor has made explicit public remarks this close to Budget Day. That, in many ways, speaks to how severe a fiscal situation the UK finds itself in.

What did Chancellor Reeves signal ahead of the UK Budget?

There were, in my mind, three principal takeaways from Reeves’s remarks:

1. -The Chancellor all-but-confirmed that the OBR will be downgrading its trend productivity growth forecasts

2. -Reeves noted that she is seeking a greater degree of fiscal headroom (>£9.9bln that was left in the spring) to protect against future shocks
3. -Reeves refused to repeat the manifesto promises not to raise income tax, national insurance, or VAT

Putting all this together, in short, means that however significant a degree of fiscal tightening that was expected to be delivered, the Chancellor is likely to deliver much, much more.

How much fiscal tightening should markets expect?

Quite how much remains something of an open question, though my best guess is that Reeves will seek around £35bln of measures at the end of the month, made up of:

• -£20bln from the OBR’s productivity downgrade
• -£5bln from the failure to cut welfare spending
• -£3bln from measures to cut consumer energy bills
• -Between £5bln - £10bln in seeking to build a buffer larger than the £9.9bln in the ‘Spring Statement’

One, very small, silver lining in all that is that there is likely to be a negligible impact from higher government borrowing costs. A recent fall in long-end Gilt yields, driven largely by the softer than expected September inflation figures, makes it likely that market-based interest rates were hovering around the same place in the autumn forecast snapshot window, as they were during the spring.

Is the UK preparing for a new wave of tax increases?

Taking the above into account then brings us to the question of how that fiscal tightening will be comprised.

Spending cuts can, for all intents and purposes, be ruled out. Not only has the Chancellor done almost nothing to ‘roll the pitch’ for public spending restraint, Labour MPs would almost certainly not vote in favour of such an outcome. This summer’s welfare spending debacle evidences this, where the Chancellor was forced to hastily re-write legislation on the floor of the Commons in order to convince MPs to vote for a slower increase in spending, let alone a real terms cut.

As a result, and with a greater degree of borrowing also essentially impossible against such a febrile Gilt market backdrop, tax hikes are almost certain to be the chosen option.

Will income tax rises lead the UK’s fiscal tightening?

With Reeves having refused to repeat the aforementioned manifesto pledges, it seems incredibly likely that an income tax hike is now on the cards. A VAT increase can, effectively, be ruled out due to its inflationary impact, while changes to national insurance are unlikely, with that lever having been pulled last year.

Income tax changes are likely to come in two distinct ways.

Firstly, the freeze on income tax thresholds, in place since 2022, and currently due to expire in 2028, looks set to be extended once more. This, over time, causes an effect known as ‘fiscal drag’, whereby an increasing number of employees are dragged into higher tax thresholds as earnings increase, but the thresholds remain unchanged. Freezing these thresholds is likely to raise around £10bln a year.

Secondly, an outright increase in income tax rates is likely to be delivered. Increasing the higher rate of income tax, likely an easier ‘sell’ to Labour MPs and voters, would raise around £1.5bln per annum, barely a ‘drop in the ocean’ in the grand scheme of things. Consequently, the balance of risks increasing tilts towards the Chancellor increasing the basic rate of income tax, where a 1p increase would raise between £6bln - £7bln a year.

For context, no Chancellor has raised the basic income tax rate since all the way back in 1976. That same year, the UK was forced to go ‘cap in hand’ to the IMF for a bailout, so here’s hoping history doesn’t repeat.

What other tax measures could Reeves introduce?

Though these tax hikes would be significant, these measures alone would still leave a significant shortfall compared to the £35bln tightening that looks necessary, in the Treasury’s mind.

Hence, a smattering of other, smaller, tax hikes will likely also be delivered, though the exact composition of these measures is still highly uncertain at this stage, not least with pre-Budget ‘sources’ stories having floated the possibility of tweaks to well over 100 different taxes at this stage.

It seems likely, however, that the Chancellor will seek to increase national insurance contributions paid by LLPs (raising approx. £2bln), in addition to tweaking various gambling duties (raising approx. £3bln). There is also the potential for Reeves to increase fuel duty, which has now been frozen since all the way back in 2011, with there also being various rumours alluding to a possible ‘Mansion Tax’, an increase in the bank surcharge, changes to preferential tax treatment for pensions, and even an ‘exit tax’ for those seeking to emigrate.

How have markets reacted to Reeves’s fiscal stance?

Financial markets have traded in somewhat mixed fashion in recent weeks, though the overall backdrop remains an incredibly fragile one.

Though Gilt yields trade close to YTD lows, especially at the long-end of the curve, the market continues to lack confidence in Reeves’s stewardship of the economy, especially considering the lack of specifics given in terms of revenue raising measures. The pound, meanwhile, trades at its lowest level since April, with spot cable now perilously close to testing the 1.30 figure to the downside, as the market prices a much weaker GDP growth outlook on the back of the near-certainty of higher income taxes.

What does Reeves’s approach mean for the UK’s economic outlook?

All-in-all, Chancellor Reeves’s remarks will have done little to soothe anyone’s nerves – be it those of market participants, the electorate, or Labour MPs – as we near Budget Day. In fact, the likelihood is that the Budget will simply result in the UK economy slipping even further into a ‘doom loop’, with the coming tax hikes raising nowhere near the amount of revenue envisaged on paper, thus leaving yet another ‘black hole’ to be plugged in a year’s time.

Unless, and until, there is a broad recognition that UK public spending is on an unsustainable path, and the Treasury demonstrate a much greater degree of spending restraint, the outlook for the GBP will remain a dour one, while risks to Gilts will likely continue to tilt to the downside.