Tax and spend UK Budget

The UK Budget today cheered the Gilts market because it was not worse! Public sector net borrowing is projected to decline from 4.5% in the current tax year (to April 2026), to 3.5% in 2025-26 and on down to 1.9% in 2029-30. The Chancellor stuck to her fiscal rules, raising taxes on the middle classes (but not on businesses this time) to meet her rising spending commitments. Lifting the two-child cap on child benefits will placate the Left and help her to keep her job. Bond markets have been nervous of a change in Prime Minister or Chancellor, taking the government further to the left.

However, the ratio of net debt to GDP will remain constant at about 95% and there is little in the Budget to boost productivity or promote economic growth. The rising ratio of tax to GDP as well as higher taxes on work and dividends will depress private sector activity. There is no attempt to fix the anomalies in the tax system such as penal rates of income tax at certain levels and penal stamp duty rates which limit people moving for jobs.

Some good things first

There are some good things in the Budget. Keeping to the fiscal rules and not tinkering is important. The ‘headroom’ in the 2029-30 forecast deficit against adverse developments has been boosted from £10bn last March to £21bn making yet another tax raid less likely (see technical note below). And in future the Office for Budget Responsibility (OBR) will assess the finances only once a year, a sensible change recommended by the IMF. That said, the OBR still cautions that this is not an especially large buffer given the uncertainties. A recession or other shock would easily blow it open.

The lifting of the two-child benefit cap (though an unpopular move according to opinion polls) is a well-targeted measure to reduce child poverty while the return to face-to-face interviews for disability payments is long overdue.

Business will be relieved that it is not the major target this time, with higher taxes instead heaped on the middle classes.

There is also an effort to reduce fuel bills which will lower the CPI next year and help the Bank of England meet its inflation target.

Meanwhile, government investment as a percentage of GDP will run at an average 2.7% of GDP in the next few years, up from 2.5% in 2024-25. Public investment was raised as a percentage of GDP in the last years of the Conservative government and is one of the few things this government is doing, alongside planning reforms, to boost long-term economic growth. However, most of the other measures that have been taken, including last year’s increase in employer national insurance contributions, have hit profitability and the OBR expects private business investment to be weak in the next couple of years.

Tax and Spend

The underlying picture is one of rising spending and taxation. Tax as a percentage of GDP in 2029-30 will be 38%, which is 1% higher than the March forecast, 3% higher than the 2024-25 tax year and 5% higher than pre-Covid. The bulk of new tax revenues will come from freezing personal tax allowances for a further three years, (pulling more people into higher marginal rates), new taxes on ‘salary sacrifice’ schemes for pension contributions (which will severely hit higher earners), and higher taxes on dividends and rents.

Spending in 2029-30 will be 5% higher than pre-Covid. The government is making only limited efforts to contain spending, instead prioritising expanding spending on the NHS, on defence (up to 2.6% of GDP in 2026) and on government investment. 

Moreover, there was no effort to mitigate the worst aspects of the UK tax system. These include high marginal income tax rates at certain points in the distribution due to withdrawal of child benefits and the personal allowance; the high starting point for VAT which keeps many small businesses from expanding; and the onerous stamp duty on property transactions.

Indeed, on the latter, the introduction of a ‘mansion tax’ on properties over £2mn is a missed opportunity. A well-formulated new mansion tax could have been brought in at higher rates, while reducing stamp duty on transactions on expensive properties which hits a ridiculous 10% rate at under £1 mn pounds. The decision to use value bands for the mansion tax rather than a simple percentage of value is also foolish as it will lead to endless appeals. A better model would have been a simple 0.5% tax on values over £1mn. With a percentage scheme the valuations can be very conservative (so few appeals) while still bringing in good revenues.

Overall this is a typical ‘Labour Budget’. Raising spending while boosting taxes enough to show an improvement in the deficit and keep the Gilts market calm. But the rising burden of tax will restrain work, enterprise, investment and growth.

A technical note:

Ahead of the Budget there was much talk that the OBR would reduce its projection for productivity growth which, together with higher Gilts yields than earlier projected, would open up a hole in the budget requiring higher taxes. The 0.3% pa reduction in forecast productivity did indeed reduce revenue projections for 2029-30 significantly but this was offset by faster projected wage growth (pulling people into higher tax brackets). The Chancellor still needed to raise taxes by  £26bn because of the reversals of welfare reforms proposed back in March (already announced), the ending of the two-child benefits cap and the need to create a larger buffer against adverse developments.