IFS: Budget decisions on tax, spending and debt could shape domestic policy for the whole parliament

The Chancellor has inherited an unenviable public finance situation. Taxes are at a historic high and yet debt is high, rising and only barely forecast to decline in five years' time, while many public services are showing obvious signs of strain.

Just to fund this year's pay pressures on a permanent basis and to honour the specific spending commitments in the Labour manifesto, we estimate that her predecessor's plans for day-to-day departmental spending will need to be topped up by £14 billion in 2028–29. This would still mean making real-terms cuts to spending on some public services. To avoid such cuts, we estimate that she would need to increase her day-to-day spending plans for 2028–29 by a further £16 billion, taking the average real-terms growth over the four years starting in April to 2.0%. So, just to fund this year's pay settlements and avoid future cuts Rachel Reeves would need to top up day-to-day spending by some £30 billion above her predecessor's plans by 2028–29.

This is completely aside from any promise to ‘invest, invest, invest' and the recent debate around possible changes to the definition of debt in the fiscal rules, to allow for more borrowing for investment. A tweak to the debt rule would do almost nothing to ease the challenge on public service funding, where Ms Reeves will be constrained by her (sensible) promise to meet all day-to-day spending out of revenues. Our Green Budget forecast suggests that, even with Labour's planned £9 billion tax rise implemented, achieving current budget balance whilst avoiding cuts to public service spending would be on a knife edge, and highly sensitive to OBR judgements about growth, inflation and much else.

Merely sparing budgets from real-terms cuts may well prove incompatible with ambitious improvements to public service performance, given the well-known pressures on areas such as prisons, the police and local councils. Increasing funding for day-to-day spending on these ‘unprotected' areas in line with national income would require funding to be topped up by a further £17 billion (or £47 billion in total) in 2028–29. Even this would only take average real-terms growth over the four financial years starting in April to 2.8%. That would be less generous than the 3.3% initially planned at the 2021 Spending Review (though the subsequent surge in inflation eroded that to 2.2%).

The upshot of this is, even if the debt rule is changed so that on the current measure debt continues to rise in the final year of the forecast, Ms Reeves will still need tax rises to avoid spending cuts and meet her pledge to borrow only to invest. If she wants to keep spending rising with national income, she could need up to a total of £25 billion of tax increases. Given the pledges she has made not to raise the main rates of income tax and corporation tax, or to increase National Insurance or VAT at all, she might struggle to implement a tax rise on that scale. It would be bigger than the net tax rises implemented in July 1997 and October 2010 (both around £13–14 billion). In which case she might have to live with day-to-day spending on many public services falling as a fraction of national income.

These are among the headline findings of the 2024 IFS Green Budget, funded by the Nuffield Foundation and produced in association with Citi.

There are several challenges facing Ms Reeves:

• Some of the in-year spending pressures identified by the new government stem from the poor budgeting practices of the previous government. But most spending pressures stem from the fact that the generosity of departmental budgets has become detached from what those departments have been asked to deliver. Cumulative economy-wide inflation has been twice as high as originally forecast over the three years covered by the last Spending Review, and the population is now 1 million bigger than expected.
• The March 2024 Budget forecast that spending on debt interest, and on state pensions and social security benefits, would over the next few years both be much higher as a share of national income (by the equivalent of £39 billion and £32 billion a year, respectively) than prior to the pandemic. This is having a big effect in squeezing scope for spending elsewhere without additional tax rises. The increase in spending on benefits to support those with disabilities and health-related conditions is particularly big – and worrying. Meanwhile, spending on the NHS continues to rise and, for the first time in many decades, the defence budget seems more likely to be increased than to be cut.
• Crucially, things could get harder over this parliament. By Autumn 2028, the forecast horizon will have moved forwards to 2033–34. Based on projections from the Office for Budget Responsibility (OBR), the current budget could by then be in deficit by 1.6% of national income or £44 billion in today's terms, reflecting spending pressures on areas such as healthcare, and the predictable disappearance of tax bases for fuel duties (as electric vehicles become increasingly common) and tobacco duties. In other words, further tax rises or spending cuts could be required before the end of the parliament.
• There is a case for more investment spending focused on productivity-enhancing projects. Avoiding real-terms cuts to investment spending by departments would, we estimate, require an additional £4 billion in 2028–29 on top of the £6 billion additional investment committed to in Labour's manifesto. Growing capital spending in line with national income would require spending to be £19 billion higher in 2028–29 than previous government plans (around £13 billion more than was promised in the Labour manifesto). The Chancellor could go further still. But not all investment is growth-enhancing, and the OBR's model suggests the growth-promoting effect of the average public investment project is neither huge nor swift to materialise.

The analysis by Citi highlights the UK's dire productivity performance over the last two decades. UK economic activity is 36% lower than it would have been had it continued to grow in line with trend growth before the financial crisis, compared with 31% in the Euro Area and 24% in the United States – with the gap in relative performance widening since the pandemic. GDP in the UK is now 6.1% short of its pre-pandemic trajectory, compared with 4.3% in the Euro Area.

The economic outlook outlined here reflects a material shift in the economic balance of risks. Citi expects headline CPI to undershoot the 2% target through much of 2026, with the full impact of the big rise in interest rates still to work through, the labour market weakening and the risk of embedded inflation receding. Monetary policy should be as tight as necessary to deliver price stability but as loose as possible to maximise growth. Citi suggests the Bank of England is being too inflation-averse at present. Further delay on rate cuts risks greater economic scarring and ultimately larger rate cuts in the years ahead.

The UK urgently needs to address its low growth equilibrium. Investment will be an important component of the answer. However, Citi's view is that significant extra borrowing to fund that investment would be risky. Already elevated debt levels, substantial borrowing and a current account deficit mean the UK is subject to constraints here that are not in play in either the Euro Area or the United States. Some additional investment may therefore need to be financed through higher taxes.

A compelling growth plan will require sweeping reform around issues such as underinvestment in intangibles and skills mismatch, not just investment. An increasingly challenging global economic environment makes it all the more important these challenges are addressed. As supply conditions improve, the middle of the parliament should present an economic window of opportunity. It is crucial this is seized. The UK no longer has time to spare.

Paul Johnson, Director of IFS, said:

‘The first Budget of this new administration could be the most consequential since at least 2010. The new Chancellor is committed to increasing investment spending, and to funding public services. To do so, she will need to increase taxes, or borrowing, or both. Taxes are at an all-time high, and she is tightly constrained by her pledges not to raise the main rates of income tax or corporation tax, or to increase National Insurance or VAT at all. The temptation then is to borrow more, perhaps changing the definition of debt targeted by the fiscal rules. But, given her pledge to balance the current budget, that would not free up additional resource for day-to-day spending and in any case is not risk-free given the dual deficits – that is, both budget deficit and current account deficit – being run by the UK.

‘It is easy to think that we face a short-term challenge somewhat artificially created by a particular set of arbitrary fiscal rules. That would be a mistake. Pressures on health and pension spending will continue to increase, and revenues from fuel and tobacco duties will fall. That will make remaining on course for current budget balance harder over the course of this parliament. If Ms Reeves does not grasp the nettle on 30 October, it could come back to sting her again before the next election.'

Benjamin Nabarro, Chief UK Economist at Citi, said:

‘There are cautious reasons for optimism in this economic forecast. Large supply shocks that have choked the UK economy over recent years are easing, the underlying picture subsequently improving. Nonetheless, we still face challenges. Recent policy errors – particularly on the fiscal side – now leave firms and households facing simultaneous monetary and fiscal headwinds, just as the residual inflationary risks fade. This risks a more protracted period of softness than is strictly necessary. From a monetary policy side, that also suggests the risks are increasingly shifting from inflation to the labour market. The MPC must be attentive to the associated shift. For now, the MPC seems determined to secure further evidence of disinflation before meaningfully shifting. This increasingly risks waiting too long.

‘Near-term challenges notwithstanding, an improving supply picture does now create room for a more rapid rebound through the middle of the parliament. This, in turn, presents a notable opportunity for structural reform. If we are to lift trend growth, it is essential this opportunity is seized. More investment in physical assets may be necessary to meet additional challenges, but conventional investment is not the main driver of the UK's growth slowdown to date. Reform, as well as investment, will be crucial. As the global economic environment becomes more challenging, lifting trend growth will become all the more important. Unfortunately, large outstanding debt stocks and a current account deficit mean the UK faces budget constraints that many other advanced economies don't. Additional borrowing may therefore have to be used sparingly and reform used creatively.'

Mark Franks, Director of Welfare at the Nuffield Foundation, said:

‘How the government meets its fiscal rules in the forthcoming Budget will have significant implications not just for the public finances but for people's lives and well-being, now and in the longer term. As this report shows, future public sector pay settlements could fundamentally shape the quality and availability of the public services we all rely on. Adult social care is used by some of the most vulnerable members of our society, yet current funding is fragmented and unsustainable, leading to unequal and inadequate outcomes that need to be addressed. Addressing child poverty is likely to involve making unenviable trade-offs, where the policy options taken will affect which families are lifted out of poverty and which are not. The IFS's analysis highlights the difficult choices the government faces as it makes these challenging and vital decisions.'

ENDS

Notes to Editor

1. An online press briefing will be held today from 10:00 to 11:15, via Zoom, ahead of the full public launch of the IFS Green Budget 2024 on Thursday 10 October. Chaired by IFS Director Paul Johnson, there will be plenty of time to ask your questions to the chapter authors.
   
   
2. The Green Budget 2024 will be launched at an online event on Thursday 10 October. Chapters covering public sector pay, child poverty and capital gains tax have been pre-released, and an additional chapter covering social care is also released today. 
   
   
3. About Citi Research & Global Insights: Citi focuses on delivering the highest quality economic, thematic, industry, and company research and insights to our clients globally. Citi is committed to maintaining the highest level of independence and objectivity in its proprietary research products and insights.
4. About Citi: Citi is the world's most global bank with an on-the-ground presence in 95 countries, more than 100 million customers, and over 230,000 employees. Our global network gives us the ability to connect and do business in nearly 160 countries using both our local banking licenses and our on-the ground expertise, including in-depth understanding of local politics, business, and economic conditions. Our global network also allows us to move the equivalent of Germany's GDP each day across borders, currencies and asset classes.
   
   5. About the Nuffield Foundation: The Nuffield Foundation is an independent charitable trust with a mission to advance social well-being. It funds research that informs social policy, primarily in Education, Welfare, and Justice. The Nuffield Foundation is the founder and co-funder of the Nuffield Council on Bioethics, the Ada Lovelace Institute and the Nuffield Family Justice Observatory. The Foundation has funded this project, but the views expressed are those of the authors and not necessarily the Foundation.