Rachel Reeves is rapidly running out of wriggle room amid higher borrowing costs, stubborn inflation, a sluggish economy and a promise to find billions of pounds for additional defence spending.
On Tuesday, the chancellor will get the final verdict from the Office for Budget Responsibility (OBR) before her 26 March spring statement on whether her fiscal rules have been smashed apart by increasing financial pressures since last autumn’s budget.
After a whistle-stop tour of South Africa earlier this week for meetings with G20 finance ministers to emphasise the importance of increasing defence spending, it is widely expected Reeves will be flying back to bad news.
The OBR’s final “pre-measures forecast” will be key because it will show the chancellor how much headroom, if any, is left within her self-imposed fiscal rules. It will therefore underpin any action she must take. Reeves’s policy decisions will then be incorporated into the final economic and fiscal outlook report published alongside the spring statement.
What has happened to the chancellor’s headroom?
Back at the October budget, Reeves had held back £9.9bn of headroom in reserve against her primary fiscal rule – requiring day-to-day spending to be matched by tax receipts in the fifth year of the forecast.
However, the government has been borrowing more than the OBR forecast, and Britain’s debt servicing costs have risen sharply on financial markets.
Analysts at Capital Economics expect this could whittle down the chancellor’s headroom from £9.9bn to £2.8bn. However, there are other factors that will influence the OBR’s assessment.
An economy under pressure
Growth in the UK economy has been weaker than forecast in October, having narrowly avoided a recession in the second half of 2024. The OBR is widely expected to nearly halve its 2% growth forecast for 2025 closer to 1%. In addition to the rise in borrowing costs, analysts say a weaker growth outlook could eradicate the chancellor’s headroom.
The danger was highlighted by the Bank of England after it halved its GDP growth forecast for 2025 from 1.5% to 0.75%.
Inflation is also expected to stick at higher levels than anticipated by the OBR. Back in October, the watchdog had forecast 2.6% inflation in 2025. The Bank now expects it to peak at 3.7% in late summer.
Business leaders have cautioned Reeves’s autumn budget has added to the economic headwinds, arguing the £25bn increase in employer national insurance contributions will force them to cut jobs or raise prices.
However, Reeves told the Guardian last week there would be no U-turns on the autumn budget. “I’m not resiling from that budget in any way. It was a budget that enabled us to start cutting NHS waiting lists, put more money into defence and return stability to our economy.”
What can the chancellor do?
The Treasury said the fiscal rules were “non-negotiable”, in a signal that an OBR forecast showing a breach would lead the chancellor to cut spending or raise taxes to ensure they were still being met. With Reeves having promised not to raise the Treasury’s three biggest revenue raisers – income tax, VAT and national insurance – and under pressure to fund a revival in public services, that will be tough.
Charlie Bean, an ex-member of the OBR and a former Bank deputy governor, said it would be better for the chancellor to either allow borrowing to rise – breaking the fiscal rule – or to announce a broad-based tax rise.
“A more adult way of proceeding would be for a chancellor to say: ‘OK, well I am now overshooting my rule by a few billion or whatever, but we know forecasts bounce around. I haven’t completed the spending review and I will come back to this in the autumn’,” he said.
“That said, simply saying that probably won’t cut the ice at the current juncture – and in particular given her credibility personally has probably been somewhat weakened.”
Showing the lack of wriggle room, Keir Starmer’s promise to increase defence spending to 2.5% of GDP by 2027 involved cutting the international aid budget, after Reeves warned “tough decisions” were needed to stick to the fiscal rules.
To counter the rise in debt servicing costs and a sluggish economy hitting the government finances, Reeves has indicated she will prioritise spending cuts and “rooting out waste”.
This could mean tougher restraint on public spending in the later years of the parliament, although details are still being worked on for the spending review – due to be completed in June. Benefit cuts could also be announced, to the dismay of charities and Labour backbenchers.
Reeves had promised late last year there would be no more tax rises, aiming to assuage business anger after her autumn budget. But the strength of her language on this point has softened in recent weeks. The Financial Times also reported that Reeves was leaving the door open to changes – including a possible extension of the freeze on income tax thresholds beyond 2028.
Reeves said last week that she was committed “not to be repeating anything like that I had to do in October,” when she announced £40bn of tax rises, but did not rule out smaller revenue-raising measures.
“There’s no way the chancellor is going to box themselves in to the extent that they are going to rule out ever making changes to taxes again. I’m not going to fall into that trap,” she said.
