Budget Groundhog Day
Gerard Lyons explores how the Chancellor’s Budget may involve significant fiscal tightening, likely through tax measures, to rebuild limited headroom and maintain credibility. With OBR forecasts and productivity concerns shaping the outlook, the scale of adjustment remains uncertain. Markets will watch for credible steps that balance fiscal discipline with growth to avoid another “Groundhog Day".
This will be an economically damaging Budget, as the Chancellor tightens fiscal policy significantly by hiking taxes.
It has been clear for some time that we would reach this point. Following the Chancellor’s Spring Statement in March, I wrote on these pages that we were “Heading for Groundhog Day in the October Budget”. That is where we now are, although the precise scale of tightening remains uncertain.
The outcome will depend on two factors: the Office for Budget Responsibility’s (OBR) economic assessment and whether the Chancellor opts to increase her fiscal headroom.
This headroom is the buffer the Chancellor builds into her fiscal sums to allow flexibility when circumstances change. The small size of this buffer lies at the heart of her current challenge.
Last October, in her first Budget, she set the headroom at £9.9 billion, equivalent to just 0.3 per cent of GDP, which was tiny. Her predecessor Jeremy Hunt had also chosen to reduce his own headroom in the years before the last election to create space for tax cuts.
Traditionally, the headroom was far higher because the margin of error in economic forecasts was considerable, and fiscal numbers can shift significantly in response to economic, financial and political developments.
Equally unwisely, Rachel Reeves chose to maintain only a small headroom when she became Chancellor. In her first Budget, she also raised public spending by around £69 billion, financed through higher borrowing and taxes. The latter has already damaged employment and growth prospects.
The Chancellor committed herself to three fiscal rules. The main one was to borrow only for investment and to have the current budget in surplus by 2029/30. The second is to ensure that public sector net financial liabilities fall as a share of GDP. The third is to control welfare spending.
By her Spring Statement in March 2025, she was on course to miss her main rule by £4.1 billion. She therefore announced spending curbs to restore the headroom to exactly £9.9 billion. However, Labour MPs subsequently voted against slowing the pace of welfare spending growth. This, plus higher borrowing costs means around two-thirds of her headroom, or approximately £6 billion, has already disappeared. The Chancellor needs to find funds to restore this.
Because her headroom was so small, her entire fiscal framework has become vulnerable to any change to the OBR’s forecasts. The process has become back to front. The OBR’s economic projections now dominate the fiscal landscape and create the impression that it, rather than the Chancellor, determines the key numbers.
Each time the OBR alters its outlook, the Chancellor’s sums must be redrawn. It is also for the OBR to decide how to incorporate, or “score”, any policy measures the Chancellor plans to announce in the Budget.
This dependency has led some to call for the fiscal rules to be abolished. That’s not credible. Removing them now, from a position of weakness, would unsettle the markets.
The OBR’s updated assessment could add around £24 billion to the amount the Chancellor must tighten, bringing the total fiscal squeeze to about £30 billion.
At the time of the Spring Statement, the OBR forecast growth of 0.9 per cent in 2024, followed by 1 per cent this year, 1.9 per cent in 2026 and around 1.75 per cent over the rest of the decade. It would be no surprise if next year’s forecast were cut to about 1 per cent. The economy is weak, and the three months of uncertainty preceding this Budget have hardly helped.
More significantly, the OBR will lower its estimate of productivity growth by 0.3 per cent, which will in turn trim its medium-term growth forecast. The OBR had been too optimistic on productivity compared with the wider economic consensus.
The Chancellor will likely use this as an opportunity to blame Brexit and the previous government for her predicament. The reality though is that we are suffering from the hit to productivity as a result of the 2008 global financial crisis. Since the referendum and the UK’s departure from the EU, Britain’s growth has actually outpaced both France and Germany.
The £30 billion tightening could increase if the Chancellor chose to increase her headroom and not just restore it. To avoid fears of another Groundhog Day next year, the Chancellor must rebuild fiscal credibility and restore a more substantial headroom.
There is no single benchmark for what this should be, but doubling it would be credible. That would push the total fiscal tightening to closer to £40 billion. The more credible the numbers appear, the more likely it is that gilt yields will ease and sterling will stabilise after the Budget.
The best way to close the fiscal gap would be to slow the growth of expenditure, particularly welfare payments. Instead, the burden is likely to fall on tax increases for political reasons.
The Chancellor faces a choice: either a piecemeal series of smaller rises, whose effects are hard to predict, or a break with Labour’s election pledge not to raise income tax, VAT or national insurance. Those three major taxes have the broadest base and are therefore the most effective way to raise large amounts of revenue.
Under the Conservatives, public spending almost doubled and the tax take reached record highs. Income tax thresholds were not indexed to inflation, pulling more workers into higher tax bands. The top one per cent now pay about 28 per cent of income tax, while the top ten per cent pay around two-thirds. Yet, as the OBR pointed out last year, the average worker’s effective tax rate fell to its lowest level since 1975, a fact largely obscured by the cost of living crisis.
The likely outcome is a combination of a series of smaller tax increases together with a rise in the income tax rate as part of a broader tax switch, with national insurance being cut by two pence for those with earnings below around £50,000.
The measures could include: freezing income tax allowances in future years; increasing property taxes through higher council tax on expensive homes; extending national insurance to partnerships and rental income; higher fuel duties and mileage charges for electric vehicles; rises in gambling and sin taxes; and adjustments to inheritance and capital gains tax.
To keep markets onside and prevent expectations of another Groundhog Day next year, two elements are essential: tax increases must be credible and broad-based, and fiscal headroom must be rebuilt. Markets will also watch closely to see that the tightening does not choke growth entirely.
The Bank of England may provide some relief, with markets currently expecting two rate cuts to 3.5 percent by next summer and 3 percent by the end of 2026. These seem plausible, although 3.25 percent by next summer is possible with a rate cut to 3.75 percent likely in December.
For now, the reality is stark. This Budget risks becoming a rerun of last year’s mistakes, another Groundhog Day that drains demand and confidence at precisely the wrong time.
