Budget 2026 reaction: Ambition meets fiscal constraints

Another shock, another near-term delay in fiscal consolidation

Today’s Budget, the first under new Chancellor John Healey, was essentially written with a lowercase ‘b’: its net average fiscal impact came with a broadly neutral absolute impact of on average just 0.02% of GDP, or £1.3bn per annum over the forecast horizon. There is little doubt that the ambition of the Labour Party has stepped up under new Prime Minister Andy Burnham. But fulfilling it is much constrained by the state of public finances. For reasons outside the government’s control, namely the outbreak of the Iran conflict, which came just after the OBR had completed its previous forecasts in March, this looks gloomier than it did for Rachel Reeves. And demonstrating fiscal prudence to markets has become non-negotiable for UK governments since Liz Truss.

As a result, Healey had to largely hold back on tackling the bigger issues that Burnham has promised not to avoid during his tenure as Prime Minister. What this Budget (or budget) did not do was find funding for a rise in council house building, for defence spending to meet the 3.5%/GDP target in 2035 or for the promised new National Care Service in England. The Chancellor made it clear these remain key priorities and referred repeatedly to the Spending Review next year as the time to expect more on this and on welfare reform, following the publication of the final reports by Alan Milburn and the Timms panel next month. In other words, much as we expected, the can was, in effect, kicked down the road on these.

Instead, today’s focus was on dousing the immediate fires, by offering front-loaded ‘breathing space’ to lower-income households and smaller firms. This means somewhat slower fiscal consolidation than previously planned to start out with. To keep the overall impact neutral – the nod to ‘fiscal prudence’ – not only were these measures kept fairly modest, but they are funded. This was done by new measures to collect a larger portion of the taxes that are due and by some tax rises as well as some extra departmental spending cuts in FY2031/32. In other words, there is the promise of faster backloaded fiscal consolidation to balance the books. We detail the new measures in the section below.

That said, the Budget also relies on a marked reduction in the fiscal ‘headroom’ from £24bn to £15bn. The deterioration in the underlying economic forecasts – higher interest rates in particular – reduced this headroom by £11bn, and Chancellor Healey’s new measures added just £2bn to it. This means the Chancellor is running with a smaller margin for error when it comes to meeting one of his two key fiscal rules, namely the fiscal mandate, or ‘stability rule’, which stipulates the current budget deficit must be in surplus in FY2029/30. (The margin with which the second key fiscal rule, the ‘investment rule’, is met, is also reduced, but by less, from £27bn to £24bn. This rule stipulates that debt based on the Public Sector Net Financial Liabilities measure should be falling by FY2029/30.) 

Using some headroom in the current circumstances seems perfectly defensible: after all, the point of a buffer is arguably that it can and should be used at times when unexpected shocks hit. This is all the more so if there is a prospect that the underlying cause – the Middle East conflict – might be resolved relatively soon, which could then unwind the energy squeeze, and the fiscal costs associated with it, over the coming years. Letting the headroom take the strain is not risk free; particularly pertinently given the selloff in bonds so far this year, the OBR noted for instance that 1%pt rise in gilt yields and Bank rate expectations could add £16bn to the current budget deficit in the medium term. Yet clearly there is a fine balance to be struck between under- and over-insuring for future events that could push the public finances off the currently predicted trajectory. Investors had indicated previously that they would be comfortable with the Chancellor running with headroom of around £15bn, and Mr Healey clearly took note.

Measures – a little bit for everyone but tougher decisions to come

Despite the military-style security that was reportedly implemented around Budget discussions, there were no real blockbuster surprises in terms of measures from Healey’s address to Parliament today. This was mostly because Chancellor Healey took the approach of many small measures that help at the margins, rather than one or two large unexpected policy changes that really shift the dial. As Chancellor Healey said, it was a Budget for “the worker, the sole trader, the parent at the school gate, the young person desperate to start their first job or start their first business”. It was also a Budget for Healey and his PM Andy Burnham, in the sense that it provided them a little bit of extra time before having to decide on the big spending decisions, such as on defence, welfare and youth inactivity. These decisions will wait until next year.

Among what Chancellor Healey did announce, there was understandably a lot of focus on bringing down energy costs. However, as past governments know well, this help can be extremely expensive, and thus the Chancellor and his team have designed the package of support so that it is not only targeted but also time-limited. This has the benefit that the cost of such packages does not show at the time in which the fiscal rules bind (i.e. FY2029/30). However, as previous governments have also found, politically it is often difficult to take support away from the electorate. Fuel duty is a prime example, this was frozen again in today’s Budget (despite successive governments promising future increases, it has been frozen since 2011). It now will not be increased until July 2027 at the earliest, while the 5p temporary cut to fuel duty has been extended for another six months, also until July 2027. The government additionally announced that the temporary VAT cut on electricity bills will also be extended until July 2027, taking around £50 off the Ofgem energy price cap in April of next year. The fuel duty freeze and VAT off domestic electricity bills will cost £1.3bn in FY2026/27 and £1.1bn in 2027/28, but as the schemes will then end, will cost nothing in FY2029/30, against which the fiscal rules are assessed. The bigger expense to the exchequer though was the surprise announcement that those in council tax bands A to D will receive a £100 household energy payment next year, at a cost of £2.6bn in 2026/27. Again, given that it is a one-off, it will not impact borrowing further out.

Another key policy focus in the Budget was housing. The Chancellor announced an extra £1.5bn in funding for social and affordable housing. To incentivise building, there will be a new zero rate of VAT on land intended for the construction of social housing. The government will also exempt smaller housing developments on brownfield land from certain environmental requirements. Healey pledged that there the government will not make major changes to building regulations for the remainder of the parliament, except essential safety regulations. On the demand side, Healey focused on first-time buyers, reiterating the government’s new ‘Your First Home’ scheme which will provide 20% equity loans to first-time buyers. The red book provided the details of the scheme, with income caps of £110k per household outside of London and £140k inside, while price caps will be set based on local authority median prices. The first loans will be issued from April 2027. The Chancellor also surprised with a new first-time buyer ISA, allowing contributions of up to £4k a year with a 25% government bonus. This will replace the lifetime ISA. On broader ISA rules, Healey announced that the government will be reversing the decision to reduce the cash ISA limit to £12k a year, it will now stay at £20k per year.

Businesses were not forgotten in Healey’s Budget, although support was targeted at smaller companies. The government will increase the Small Business Rates Relief threshold from £12k to £18k for 100% relief, meaning that half of all retail, hospitality and leisure properties will pay no business rates. It will also increase the tapered relief threshold from £15k to £21k.

There was also a big focus on entrepreneurs and trying to incentivise people to start a business in the UK. The main measure is the new Founders’ Relief. This will introduce a new, lower Capital Gains Tax (CGT) rate of 10% on up to £10 million of lifetime gains for founders of high-growth, innovative companies. Meanwhile to support entrepreneurs in their early days, the government is tripling the Trading Allowance to £3k, while piloting a Young Entrepreneurs Allowance, which will provide successful applicants with support towards their living costs during the first year of their business.

Pensioners also received a lifeline, in that the government will introduce the Pension Tax Allowance (PTA) to ensure that pensioners who rely solely on the state pension will not have to pay income tax on this. This has been introduced as the state pension is set to rise above the personal allowance threshold next year.

In addition, Chancellor Healey offered support for industries that could be growth engines for the future, such as AI. He also outlined some measures that would back one of PM Burnham’s main visions: greater devolution. The Chancellor revealed that mayors will have greater tax powers in the coming years: they will be able to keep 20% of business rates revenues from next year, and a share of income tax by 2028, with the idea that this will be spent on projects that will boost economic activity in local communities. For example, in London it could be used to fund the Bakerloo underground line extension.

The last big spending measure was on defence, although this was not a surprise given that it was revealed in the summer that the government would need to fill a £4.7bn gap in the Defence Investment plan. The Chancellor revealed this will be paid for by a reprioritisation of capital budgets. This is just small beer relative to the amount of extra defence spend that will be required over the coming years though, if the government is committed to hit defence spending worth 3% of GDP by 2030, and 3.5% by 2035 as Healey suggested today. For now, though Chancellor Healey has kicked that particular can down the road.

Although the individual spending measures are fairly small, they do add up, particularly so in the current fiscal year, where much of the extra spend is frontloaded into. Indeed, the direct effect of the spending measures is £5.95bn in FY 2026/27. The Chancellor has asked the banks to cover some of these early costs, raising the bank corporation tax surcharge from 3% to 6% for 15 months, raising £1.5bn. Supplementing this, the Chancellor is increasing the rate of machine games duty, lifting the tax rate on savings and property income by 2%pts. There is also the standard savings from tackling fraud and error, whilst Healey also announced that the government will shift the responsibility of collecting VAT on sales to online marketplaces.

In all, the measures announced by the Chancellor provide a bit of ‘breathing space’ for businesses and households but are far from transformative. Healey has also provided himself and the PM a bit of breathing space too, in the sense that they are buying themselves a bit of time before having to address the thornier, much more expensive issues of defence spend, youth inactivity and also decisions over welfare. They can’t put it off forever though, and these decisions will likely form part of a Spending Review and a Budget next year.

Macro – energy shock clouds an otherwise resilient outlook

In his House of Commons address Chancellor Healey celebrated the OBR’s upgrade to UK economic growth this calendar year, despite it being only a minor 0.1%pt upward revision relative to March, to 1.2%. We think that the OBR’s forecast is actually a little on the pessimistic side: our own view is that the economy will expand by 1.5% this year and next. Our base case sees growth next year aided by lower energy prices and Bank rate cuts in the second half of the year. The OBR has a different view: it anticipates a patch of softer momentum in 2027, with growth of just 1.0% next year, a 0.6%pt downgrade relative to the March figures.

However, these macro forecasts are driven by market pricing averaged over the 10 working days to 19 August (the fiscal forecasts are driven by market pricing in the 5 working days to 15 September). This therefore assumes a Bank rate just shy of 4.50% by the end of 2027. Our view is that the Bank rate will be 75bps lower than that, at 3.75%. With such a restrictive stance of policy, it is understandable why in the OBR’s scenario business investment struggles next year (-0.5% y/y) and the unemployment rate rises (to 5.1%). If there were to be a resolution to the war in Iran, as is our base case, we are hopeful that the Bank of England could quickly reverse the precautionary hikes that it is likely to decide upon over the coming months, laying the groundwork for economic prospects to improve in the second half of next year. We therefore see an upside risk to the OBR’s near-term forecasts.

Outside of the near-term forecasts we were interested to see how the OBR would respond to latest developments that could change the longer-term fiscal picture, such as the ONS’s recent methodology changes to the productivity numbers, resulting in upward revisions. These changes revealed that the OBR had in fact not been too optimistic on productivity growth since the Global Financial Crisis, as was previously thought. The OBR dedicated a box to the new productivity data, but crucially the fiscal watchdog did not incorporate the ONS revisions, or the message they send about future productivity growth, into its forecasts. This was due to the timing of the release, which fell outside of the OBR’s forecast window. However, the OBR did say that ‘ultimately, what matters for the outlook of potential output, GDP per person, average earnings and, consequently, for the fiscal forecast, is growth in output per worker’. The ONS revisions impacted output per hour worked, not output per worker, suggesting that if Chancellor Healey was hoping for a big improvement in the finances from a productivity upgrade next year due to these revisions, he might be disappointed.

Lastly, the OBR made a meaningful downward revision to population growth. This is not a surprise to us given the trends in the latest data on net migration. Indeed, the OBR now expects net migration to be around 70k a year lower than in March, which it expects to have a small negative impact on the level of GDP and potential output in the medium term. These revisions are not judged to be the main reason for the downward revision to potential output growth over the forecast horizon though, with the OBR attributing this more to higher energy costs. Indeed, relative to the March forecast, oil prices are deemed to be 30% higher in 2026 and 2027, and around 8% higher in 2030.

Gilt issuance – an intensified move towards shorter-dated debt

When it comes to the Treasury’s gilt issuance plans, the deterioration in the underlying picture for public finances has meant an upward revision to the financing remit for issuance this year. In the April revision, issuance during the current financial year had been expected to be £246.2bn; now it is set at £250.6bn. This was a touch higher than the £249.6bn consensus in a Reuters poll of gilt-edged market makers (GEMMs) ahead of the Budget. Very much as anticipated, the bigger story came in the tilt in the maturity profile. Net T-bill issuance rose from £5bn to £8bn, and there was a heavy swing towards issuing shorter and medium-dated gilts rather than long-dated ones. Against the backdrop of rising long-dated gilt yields and structurally lower demand than in the past from pension funds for such gilts, this is unsurprising.

Conclusion: Markets give a small thumbs up for ‘doing no harm’

All in all, Chancellor Healey today delivered the ‘Do No Harm’ Budget that had been expected of him. Unfavourable conditions have made it hard to deliver on the new PM’s more ambitious longer-term goals right now. Instead, today’s announcement represented a balancing act. The challenge was to provide a series of small doses of targeted pain relief to lower-income households and to small businesses now whilst demonstrating commitment to encouraging entrepreneurship and, crucially, to longer-term fiscal prudence. The Chancellor did so through measures that are generally minor and, in principle, should net themselves out over time. Relying on fiscal consolidation in later years poses risks though: the past few years have demonstrated how a series of negative shocks can mean deficit reduction is slower than planned. Delivery of good intentions can be delayed by tricky circumstances, leaving the debt problem to rise in the interim. And whether the hoped-for favourable conditions – lower energy prices and lower interest rates – will be forthcoming by the Spending Review and next year’s Budget, allowing for higher spending without major increases in taxation, is an open question.

Still, for now, it seems a job well done. Today’s Budget has been greeted by a small thumbs-up from markets, judging by gilts having slightly outperformed their main international counterparts. Challenges ahead are aplenty, but so far so good.