What Labour's Budget means for the UK economy

As Rachel Reeves announced the Budget, she found herself walking a narrow tightrope. The chancellor sought to protect public services, boost investment and reassure markets of her fiscal credibility – all while keeping a manifesto pledge not to increase taxes on ‘working people’.

Reeves called her Budget a plan to create “wealth and opportunity for all”, adding that “the only way to drive economic growth is to invest, invest, invest”.

The big tax and spending plans announced

Despite speculation, Reeves did not extend the freeze on income tax thresholds. Yet she did announce a 1.2 percentage point increase in the rate of employer national insurance contributions (NICs) and a drop in the level at which employers start paying NI. This is expected to generate a further £25bn a year by the end of the forecast period. 

This is a significant revenue raiser, but sits uneasily with Labour’s pledge not to increase taxes on ‘working people’. Economists warn that higher employer NI contributions are usually passed onto workers in the form of lower wages. The Office for Budget Responsibility fiscal watchdog downgraded its forecast of household income growth in part.

Changes to inheritance tax and a rise in the main rate of capital gains tax will raise £2bn and £2.5bn respectively by 2029-30. Imposing VAT on private school education and a crackdown on tax avoidance is expected to raise £9bn by the end of the forecast period. In total, today's measures represent a £40bn tax increase by 2029-30. 

Reeves also pledged to improve public services and announced that day-to-day spending will grow by 1.5 per cent in real terms from 2024-25, costing £47bn. She also extended the £3bn temporary freeze on fuel duty and pledged a £2.9bn increase in defence spending next year. As expected, the chancellor promised higher investment over the next five years, made possible by the pre-announced change in her second fiscal rule.  

Earlier in the week, the government also confirmed a hike in the minimum wage for over-21s to £12.21 an hour, a 6.7 per cent increase. Reeves previously hailed the pay boost as a step towards “a genuine living wage for working people”. 

Changing the fiscal rules 

Reeves, like her predecessor, has bound herself by two fiscal rules. The first ‘stability’ rule sets out that the day-to-day costs of government must be met by revenues. This was previously measured over a five-year period, but the chancellor has tightened it to three to ensure that “difficult decisions cannot be constantly delayed or deferred”. Given the pressures on day-to-day costs, economists expect the enhanced rule to act as a significant constraint on the government’s spending plans. 

The second fiscal rule sets out that debt must fall as a share of GDP. A week before the Budget, Reeves announced that the measure of debt used would be broadened out to public sector net financial liabilities, placing more emphasis on the impact of investment on the supply side of the economy. Though Reeves loosened the rule in one sense, she has tightened it in another. Debt must now fall as a share of GDP by the third year of the Office for Budget Responsibility (OBR) forecast, rather than the fifth. 

The chancellor is on track to meet both of her fiscal rules but will be left with a relatively modest £15.7bn buffer by 2029. This is far below the average enjoyed by chancellors since 2010, and only slightly better than Jeremy Hunt’s position in the Spring Budget. Though fiscal policy is being tightened over the next five years, today's announcements add up to a slightly looser stance than the previous government set out in their March Budget.

What it means for interest rates and the economy

OBR forecasts suggest a relatively muted outlook for growth (1 per cent next year, rising to 1.6 per cent by 2029) though the watchdog does expect today’s Budget measures to boost growth over the longer term. 

Today’s announcement is unlikely to have any bearing on the Bank of England’s interest rate decision next week. According to analysts, the Bank’s November forecasts were already ‘locked in’ before the Budget, and a 0.25 percentage point cut is expected. 

Nevertheless, economists do expect the Budget measures to have some impact on inflationary pressures over the year ahead. According to the OBR, the new policies will push up inflation by around half a percentage point at their peak, driving inflation up to 2.6 per cent next year. As a result, the body raised its expectations for Bank Rate and gilt yields by 0.25 percentage points across the forecast. 

Did Reeves keep her fiscal credibility? 

From a bond market perspective, the biggest news was the change to the second fiscal rule. This was ‘pre-announced’ last week (giving investors time to digest the news) and markets were relatively unruffled by the Budget. 10-year gilt yields reached a post-election high of 4.32 per cent on Tuesday, driven by a combination of Budget uncertainty and global factors like US election jitters. After the Budget announcement, they had fallen to 4.23 per cent, as the chart below shows. 

The chancellor will put guardrails on investment spending by ensuring that the portfolio of new financial investments will be delivered by ‘expert bodies’ such as the National Wealth Fund, which must, by default, earn a rate of return at least as large as that on gilts.

The new Office of Value for Money will recommend system reforms to save taxpayers money, while the National Infrastructure and Service Transformation Authority (Nista) will advise on whether proposed investment will deliver economic growth. 

An OBR review into the ‘£22bn black hole’ in public finances gave Reeves another chance to flaunt her commitment to economic stability. According to Reeves, it found that the Conservative government “did not provide the OBR with all the information” on spending pressures, leading to a “materially different” forecast in March. Former chancellor Jeremy Hunt had tried to block the report, arguing that publication on Budget day allowed it to be used as a “political weapon”.

What can we expect in the future? 

Prime Minister Kier Starmer was clear this week about the party’s plans to “take the tough decisions upfront”, though a cynic might point out that it is easier to raise taxes when they can still be blamed on the previous government.

Yet Reeves’ modest fiscal headroom means that she might be forced to raise taxes again later in her term, especially given the constraints of tighter stability and investment rules. The chancellor used this Budget to build up her reputation for fiscal credibility – but not her fiscal buffers.