Rachel Reeves, Britain’s chancellor of the exchequer, will probably be pleased with the budget she presented on Wednesday—although not in the way it was released.
It was no easy feat raising £26.1 billion in taxes and more than doubling her headroom to £22 billion without breaching the Labour Party’s manifesto commitments and with minimal net impact on the economy over the next 12 months.
Yet Wednesday’s budget also gave no extra incentive for the Bank of England to cut interest rates further or faster than previously assumed. The lack of any growth-boosting reforms and the reliance on hikes in smaller, distortionary taxes with uncertain yields also raise the odds we face another ‘tough’ budget within a couple of years.
Markets give a cautious thumbs-up
Despite the high degree of backloading, which elevated the risk that 2025’s Autumn Budget wouldn’t be seen as credible, the gilt market’s mildly positive reaction means Reeves’s second budget seems to have passed the financial markets’ sniff test.
Gilt yields have already dropped from their recent 4.6% peak a week ago to 4.42% by Wednesday evening. The risk now is that initial positive market reactions wane over the next few days and weeks as more details from this complex budget become clearer.
OBR growth downgrade
One thing helping the chancellor on Wednesday were the growth forecast downgrades not being nearly as bad as expected.
As widely trailed, the Office for Budget Responsibility cut its productivity forecast by 0.3 percentage points to 1% per year over the forecast period. This was long overdue given the OBR’s history of over-optimism on productivity growth.
It brings the OBR’s forecast for GDP growth down to 1.5% per year—in line with our view of the UK’s trend rate of growth—and would have cost the chancellor around £16 billion in headroom.
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The chancellor will be feeling relieved that stronger—and tax-receipt-boosting—pay growth compared with the OBR’s March forecast will offset most of this deterioration.
The OBR in its latest forecast also now expects growth to be more “tax-rich” because labour income is taxed more heavily than corporate profits. All told, it means the public finances deteriorated by around £6 billion instead of the rumoured £20 billion.
The smaller-than-anticipated downgrade to the fiscal outlook gave the chancellor space to more than double her headroom and avoid a significant fiscal tightening in the near term. In fact, the budget will actually boost demand by 0.1% next year.
MPC less likely to cut rates
Stronger growth in the near-term means economic pain will be delayed. But it also reduces the chances that the Monetary Policy Committee cuts interest rates next year more than we had expected.
Admittedly, the OBR expects inflation to average 2.5% in 2026 and government policies are set to reduce inflation by around 0.3 percentage points. While last year’s regulated price hikes will persist into the first quarter, initially keeping the inflation rate higher at the start of 2026, inflation will fall below 2.5% for the rest of the year.
The MPC will most likely look through such one-off downward impacts and focus instead on underlying inflation, which will most likely be stickier. As a result, we maintain our call for interest rates to end next year at 3.5%.
Public finances remain on unstable footing
Looking at the public finances in detail, we think the Autumn Budget looks far less credible than the headlines would suggest. There are a few reasons why.
- Tax uncertainty: First, focusing on a smorgasbord of smaller taxes, which are likely to be distortionary and some of which have highly uncertain behavioural impacts and revenue yields raises the chances that tax revenue disappoints. Indeed, the Office for Budget Responsibility judges around £4 billion of policy measures to have highly uncertain yields. Measures such as levying NICs on salary sacrifice pensions lose a significant portion of revenue to behavioural effects in the long term.
- Rising spending: Second, there was little in the budget to put the public finances on a more sustainable footing in the long run. Spending is projected to be higher as a percentage of GDP than it was back in March, largely due to more generous welfare spending.
- Stagnant growth: Third, there were also no new measures announced in the budget geared toward boosting the UK’s long-term growth rate, despite the government’s rhetoric. This sentence from the OBR document is telling: “We have assessed that none of the policy measures in this Budget have a sufficiently material impact to justify adjusting our post-measures potential output forecast.
What’s more, the government still needs to find a way to raise defence spending further. Indeed, with little willingness to curb spending and no signs that the underlying causes of slow growth will be addressed anytime soon, we’re likely facing another big tax-raising Budget before long.
