Autumn Budget update

We recognised at the time that by publishing our detailed Budget preview early, on 15 October, six weeks ahead of the Autumn Budget, we ran the risk of needing to update our thoughts as new developments unfolded. Indeed, it has been a busy and, at times, chaotic period in the Government’s pre-budgetary and political diary.

The major point of fiscal controversy over recent weeks has been the prospect of a 2p hike in the basic rate of income tax, currently 20p, to help plug the fiscal gap, especially after Reeves seemingly prepared the ground for this in an unusual pre-Budget speech on 4 November. There had been speculation that a rise in the basic rate of income tax would be accompanied by increases in the higher (40p and 45p) rates of taxation, with a partial offset to the rise in the 20p rate via a 2p reduction in the rate of employees’ National Insurance Contributions. Irrespective of the precise arrangements, in the context of UK fiscal history this would have been dynamite, bearing in mind that the basic rate of income has not been raised for 50 years. Governments of various persuasions have instead favoured various forms of ‘stealth’ taxation (such as the non-indexation of allowances with inflation) and the introduction of a higher tax rate. Such a move would also have been an explicit breach of the government’s manifesto pledge not to raise ‘the basic, higher, or additional rates of Income Tax’.

These plans though were effectively killed off towards the end of last week. A report revealed on Thursday night that the government had abandoned plans to increase in the basic rate after all, which prompted a widespread sell-off in gilts on Friday as markets opened. With just this information to go on, markets concluded that PM Starmer did not have the political capital to break a key election manifesto pledge after a run-in with Health Secretary Wes Streeting over a potential challenge to Starmer’s leadership and consequently, that the government’s commitment to meeting its fiscal rules was in doubt. Tellingly, even an explanation the following morning, once the fallout in bond markets had become apparent, that the decision had been made on the back of more favourable outlook for the deficit (in the latest round of forecasts from the OBR) didn’t lead to a lasting rally, although the gilt market has stabilised so far this week.

The government currently faces a set of acute political difficulties and is vulnerable to backbench pressure on a number of issues. Moreover, of course, the wider picture is that in the opinion polls Labour is trailing Reform UK by an average gap of 11%, with some polling putting Labour behind the Conservatives and even the Greens. But while the politics is difficult, market volatility over the past few days has more to do with the communication of policies, which makes it appear as though the fundamentals are worse than they are. It should have been reassuring, not worrying, to bond markets that the need for tax rises is less than it initially appeared. We have a few points to make here.

• From the perspective of the need for a large fiscal tightening, the government is somewhat unlucky. Admittedly, some of its budgetary woes are of its own making, particularly the U-turns on the abolition of Winter Fuel Payments and the reform of Personal Independence Payments. As we explained in our preview however, probably the single biggest factor behind the need for corrective action is that the Office for Budget Responsibility (OBR) looks set to downgrade its productivity growth assumptions. These drive its medium-term GDP growth forecasts and, in turn, its projections for tax receipts and the budget deficit. The watchdog’s medium-term view of productivity has been consistently too optimistic since the end of the financial crisis with annual labour productivity growth averaging 0.5% per annum. By contrast, in the Spring Statement, the OBR’s forecasts between 2027 and 2029 averaged 1.25% which it seems likely to downgrade. The Chancellor could legitimately ask, ‘why now?’ – blame for weak productivity growth since the Global Financial Crisis  can hardly be pinned on the current government. Even so it seems that Ms Reeves has not succeeded to convince the OBR of the degree of lift that her productivity enhancing measures are likely to have, so as to stave off downgrades now. As a point of reference, each reduction of 0.1% pt in the level of productivity is equivalent to an additional deficit of £1.8bn (roughly, a 0.1% p.a. downgrade to the growth rate of productivity over the forecast horizon raises the deficit in 2029/30 by £9.0bn).
  
  
• The latest perceived wisdom is that, as things currently stand in the forecasting process, the OBR is set to increase its medium-term deficit forecasts by some £20bn. If the Chancellor wishes to raise her amount of fiscal headroom by £5bn-£10bn, as is rumoured, the necessary amount of net amount of consolidation required would be £25bn-£30bn, so approaching 1% of GDP. This is possible without an increase in the main rates of income tax but would involve a messier ‘smorgasbord’ of much smaller measures, including increased levies on individual sectors such as, quite possibly, the gaming sector and banks.
  
  
• One important consideration is that, although a near-1% of GDP fiscal tightening is material, the hit to GDP is likely to be spread out. In particular, if some £10bn or so of this can be achieved by an extension of income tax threshold freezes, these will hold back growth relative to current forecasts only from April 2028. So, only a part of the fiscal tightening will hit GDP growth in 2026.
  
  
• Moreover, our continued hunch is that the government will at some point aim to tackle the welfare bill – non age-related welfare costs are currently in the region of £150bn per annum and rising. But the Chancellor simply does not have the political backing for such a move right now, and with no appetite for cutting either public services or investment, the onus this time will have to be on taxation. It would not be a surprise however to see her presenting a larger than usual amount of measures to prevent tax evasion and fraud, in order to make a bigger dent in the deficit projections.
  
  
• We would offer a final couple of points that should in theory provide good news for the Prime Minister and the Chancellor. First, a genuine degree of fiscal tightening, even if it is less than seemed likely just a week ago, would likely help to cement the case for lower interest rates at the next MPC meeting on 18 December. Governor Andrew Bailey appeared open to change his vote from ‘on hold’ next month and although this might not be the case with the four other members of this camp, a switch by Bailey on his own would swing to the vote to 5-4 in favour of lower rates.
  
  
• Second, the noise around poor communication has obscured the fact that the economy is set to have outperformed many expectations this year. GDP growth looks set to be notch up around 1.5% in 2025, compared with OBR forecasts of 1.0% at the Spring Statement. It is quite feasible that the economy outperforms again next year, especially if interest rates continue to come down, as we expect.
  
  
• Last, it is not impossible that the Chancellor does sufficient work to repair the public finances next week and possibly in tackling the welfare bill further ahead, to be able to bring taxes down again ahead of the election. An election date in 2029 – there is simply no incentive for Labour to throw the dice early, given current polling – should mean that the pre-election Budget will focus on a reference point of 2031/32 for its fiscal rules. By then the measures taken out over the next year or so may have gained significant traction, especially if the Government manages to make inroads on the welfare bill. In political terms though this is eons away and the precarious political positions of the PM and the Chancellor mean that it is far from certain that they will still be the Labour leaders in Downing Street to deliver any good news.

This article is for general information purposes only and should not be used or relied upon as professional advice. It is advisable to contact a professional advisor if you need financial advice.