UK budget preview: Headroom and hard choices

• Macro views: The UK government faces an uphill battle to reset the fiscal narrative at this month’s budget after a downgrade to the OBR’s productivity growth assumptions, policy U-turns and fiscal slippage.
• We believe that the government will be forced to find 30-35bn in measures to offset the shortfall, provide some giveaways and increase its headroom under the fiscal rules by 5-10bn.
• With limited scope for spending restraint, the core will be tax rises. It has been reported that the government has shied away from increasing the headline rates of income tax. Instead, consolidation seems likely to take the form of frozen income tax thresholds and a muddle of small measures.
• The piecemeal approach raises the risk of misjudgements, but the chancellor seems to have learnt a lesson on distortive/inflationary policies after last year’s budget at least. A benign budget in that sense would clear another hurdle for the BoE to cut again in December.
• But the apparent backtracking on income tax rates has raised plenty of questions about the government’s wider strategy and commitment to fiscal sustainability. In the absence of more forceful action, the rinse-and-repeat cycle of fiscal speculation threatens to be a constant drag on UK sentiment.
• The focus will also quickly turn to the political aftermath. The PM is under pressure even before this tax-raising budget. The technical nature of the OBR downgrade will be a huge communication challenge. Even if the budget looks fiscally credible, policy missteps or bad presentation could see more knives come out for the PM and raise the threat of a leadership challenge.
• Markets views: The GBP has weakened ahead of the Autumn statement to reflect building expectations for BoE rate cuts. A package of fiscal tightening measures even if more back-loaded should be supportive for further rate cuts. Downside risks for the GBP is investor concerns over the credibility of the government’s fiscal plans were to intensify and/or political uncertainty picks up after the Autumn Statement.
• The government’s decision to cancel plans for an income tax hike triggered a renewed sell-off in the gilt market reflecting fresh doubts over the government’s commitment to make tough fiscal decisions that are unpopular with the public and within their own party. However, building expectations for BoE rate cuts and falling market-based measures of inflation expectations remain supportive for gilts. We expect the slope of the gilt curve to steepen as yields at the short-end come down more than at the long end.

Macro view: Markets vs MPs

2025 UK budget - Our central policy scenario | A mixture of tax rises allows for a limited increase in fiscal headroom. An extended freeze on thresholds does some heavy lifting and provides some ambiguity on whether the manifesto is breached or not. The rest of the shortfall is filled with a complicated package of smaller measures, e.g. on property, gambling and salary sacrifice restrictions. Fiscal headroom expanded to 15-20bn. Distortive/inflationary measures are avoided and some politically friendly policies introduced to directly reduce headline inflation (e.g. on household energy costs). Capital spending plans left unchanged.

The shortfall | The UK government has been sailing close to the wind with its fiscal policy ever since pledging not to hike its main revenue levers, namely income tax, National Insurance, and VAT, despite obvious pressures. It then loosened the fiscal rules (a framework to ensure the credibility and sustainability of public finances) at its first budget yet opted to leave historically low headroom of just 9.9bn. That slim figure was maintained at the spring statement in March (see our take on that, as well as a description of the current fiscal rules, here).

These decisions left the government hostage to fortune. Coming into its third major fiscal event, the narrow buffer is set to have been more than erased by a significant downgrade to the OBR’s productivity assumptions after years of disappointing outturn data. Higher borrowing costs and policy U-turns have also contributed to slippage.

Chart 1: The current budget deficit is overshooting projections

Chart 2: The timing of the OBR’s market snapshot will have helped to offset its productivity downgrade

It appears it could have been worse. The OBR has now confirmed that the window used for its snapshot of market expectations for interest rates was taken in the ten working days to 21 October. That is closer to the event than usual and coincides with a period when soft UK data brought forward BoE rate cut expectations. There have also been reports that the effect of the productivity downgrade has been partially offset by more generous OBR interpretations on other inputs such as wage growth.

We now see the fiscal shortfall at around 20bn. We also expect the headroom will be expanded by 5-10bn. Scope for action on expenditure is limited but the government could plausibly find ~5bn through ‘efficiencies’ and reprofiling of commitments further ahead in the projection horizon. On the other side of the ledger, we expect some giveaways in the form of lower household energy costs, the phasing out of the two-child benefit cap and the usual extension of the fuel duty freeze. Together that could sum to around 10bn. All told, this mix would require 30-35bn of measures.  

Tax hikes – A manifesto-testing muddle? | The chancellor, Rachel Reeves, seemed to roll the pitch for painful consolidation in a speech this month in which she talked about doing what is “right” to “build more sustainable public finances”. But, in an apparent U-turn, it has been reported that the government dropped plans to raise income tax rates at the last moment. While that implies that the fiscal shortfall is smaller than some had feared, it raises plenty of questions about the government’s wider strategy and commitment to fiscal sustainability amid brewing discontent among its own MPs.

Raising income tax rates would be the most effective, predictable and least distortionary method of increasing government revenues. An immediate move (rather than backloaded measures which might never see the light of day) could help the government convincingly reset the fiscal narrative with market participants. However, there has been little sign that this government is willing to take drastic action unless it feels it absolutely must.

Instead, we expect the government will look to plug the gap through a complicated mix of policies while muddying the waters around its manifesto commitments. Reports suggest that the chancellor will take the well-trodden stealth route by extending the freeze on income tax thresholds for a further two years. That could raise ~10bn and would certainly play fast and loose with the spirit of the manifesto pledge. It would also be a backloaded move with uncertain revenues determined by the path of future inflation.

To fill the remaining shortfall, the government seems set to implement a muddle of other measures (e.g. on capital gains, property, gambling, salary sacrifice restrictions). Plenty of these smaller tax rises are likely to be required, and they would have even less certain revenue generation potential and risk unforeseen distortionary effects.

Chart 3: The tax ratio is set to rise to long-term highs

Chart 4: Income tax is the largest source of revenue

Spending – Hard to see any meaningful action | There is limited scope for restraint on the expenditure side. Departmental spending envelopes for the next three years were set only a few months ago in this summer’s spending review. The U-turn on welfare reforms and earlier climbdown over winter fuel allowances revealed how hard it is for the government, despite its big majority, to push through even relatively small welfare cuts. The chancellor has also repeatedly highlighted the importance of capital investment, and so trimming infrastructure commitments (which can be politically easier given the long-term nature of plans) does not seem viable either.

That said, the chancellor has notably stated that she is “looking” at spending as well as taxation, so we expect some token action at least. But our expectations are low here – some token measures and reprofiling of spending further ahead in the projection horizon might be the best that can be hoped for.

How far can the headroom be raised? | We expect considerable market focus on the new headroom figure. We see an expansion to 15bn as the bare minimum and expect a figure closer to 20bn. That would still be below the 2010-19 average (32bn). Reaching that sort of mark does not look feasible without the sort of politically painful action on income tax that the government is, it seems, unwilling to pursue. An expansion towards 20bn would be a step in the right direction at least, but, as this budget is likely to show, that sort of headroom can easily be erased. As a result, the UK risks being stuck in a feedback loop in which persistent speculation around fiscal consolidation weighs on sentiment and activity, and in turn further worsens the country’s fiscal position.

On a more positive note, it's worth highlighting that the OBR’s new productivity assumptions, which are set to be the main driver of the need for consolidation, could be an overreaction to cyclical volatility. Recent numbers are more supportive of the previously projected trend growth of 1.0% – headline output per hour worked came in at 1.1% in Q3. That’s based on LFS data which has well-known issues around sampling/response rates, and the ONS alternative series derived from (possibly better) PAYE data showed a healthy pickup to 3.1% Y/Y. To our minds, it seems possible that AI-related investment and perhaps a rotation from labour to capital following the increase in employment costs could support UK productivity growth over coming years.

Chart 5: The government has left itself historically low fiscal headroom

Chart 6: The OBR is reportedly on the cusp of downgrading its productivity growth assumptions

Has the chancellor learnt a lesson on inflation? | As we’ve noted previously, the government has been making the right noises about avoiding inflationary/distortionary policies after last year’s employer NICs rise and the 6.7% increase in the minimum wage both contributed to the UK’s uptick in inflation. This recent rhetoric on inflation risks suggests that these sorts of measures will be avoided, and the freeze on fuel duty will be extended once again. However, the likely piecemeal nature of the tax rises raises the risk that at least some could have an immediate upward effect on prices.

On the other hand, there is probably some scope for inflation-reducing giveaways too. For example, scrapping VAT on household energy bills would give ministers a positive story to tell and could shave ~15bp off headline inflation. In terms of timing, we see no reason why this couldn’t be implemented as soon as January given the speed at which energy policy was revised following the energy price shock. The political boost would be higher if it were introduced during the winter months.

This would all be pertinent for the BoE. With the broad picture being one of fiscal consolidation, we still think the Budget will ultimately open the door even further to a December cut (see markets discussion below). We then see two further moves next year with rates falling to 3.25%. Significant front-loaded tax hikes would point to slower growth and lower price pressures and hence could shift expectations around the terminal rate lower, but these types of measures now seem less likely.

Markets vs MPs – Attention will immediately turn to the political fallout | Hopes of relative stability under this government after the leadership churn during the Brexit years quickly faded. The rinse-and-repeat cycle of fiscal speculation threatens to be a constant drag on sentiment. There is now also scrutiny around PM Starmer’s position as Labour leader. Even before this budget, various reports have pointed to possible plots from Labour MPs to oust the PM due to the party’s poor performance in the polls and his own dismal approval ratings. It is this weak position which probably contributed to the apparent backtracking on headline income tax changes.

Framing the need for consolidation at this budget will be a huge communication challenge given the technical nature (i.e. the OBR’s productivity downgrade). The likely breach of the pre-election pledge through tax thresholds points to political pain, even if the ‘stealth’ approach provides some deniability. With a patchwork of other tax rises on the table, the odds that at least one sparks an outsized public backlash are high.

So, even if the budget is fiscally credible on paper, clumsy presentation or ill-judged policies could raise the risks of a leadership election. Market participants would be concerned that different leadership would come from the left of the party and could loosen fiscal rules to increase spending. There was a taste of the possible reaction in the summer when speculation about the chancellor’s resignation triggered a gilt market sell-off. See below for more discussion of risks to market sentiment.  

The government will hope it can ride out the initial storm and wait for improving conditions. We believe that further progress on inflation is likely over coming months and the government will also hope that the UK economy will repeat its recent pattern of strong growth at the start of the year. But it looks like a narrow path. The obvious flashpoint ahead is the UK local elections in May next year with current polling pointing to a drubbing for the Labour party which would intensify speculation around Starmer’s future. For now, the focus will be on the unenviable task of delivering a budget that manages to placate both markets and MPs.

Chart 7: Labour’s polling support has faded sharply since the election

Chart 8: PM Starmer has now fallen behind Farage in net favourability numbers

Markets view: Doubts over fiscal credibility hit Gilts & GBP

Fiscal tightening plans supportive for further BoE cuts

The pound has underperformed in the run up to the Autumn Statement. It has resulted in EUR/GBP rising above the 0.8800-level and cable falling back closer towards the 1.3000-level. The BoE’s trade-weighted measure of the GBP is currently trading at its lowest levels since January of this year. The GBP’s recent sell-off has been encouraged by building expectations for the BoE to deliver more active easing in the year ahead which has driven yields lower both at the short and long-end of the gilt curve. 2-year and 30-year gilt yields have both fallen sharply by around 25bps from the highs at the start of October. Over the same period the BoE’s trade-weighted GBP index has declined by around -1.7%. The recent move lower for UK yields and the GBP has been encouraged by evidence showing that upside risks to inflation in the UK are easing. Inflation appears to have peaked for this year at 3.8% in September and labour market conditions continue to loosen which is supportive for a further slowdown in wage growth. Unless there is a significant upside surprise from the October and/or November CPI reports, then the BoE should cut rates again at the December MPC meeting in line with own forecasts. The UK rate market has been moving more into line with our forecast for the three further BoE rate cuts by next summer.         

We expect the upcoming release of the government’s Autumn Statement to be supportive for our forecast for further BoE rate cuts. In our base case scenario, we expect the package of fiscal tightening measures to act as a modest drag on growth in the year ahead, with a slowdown from 1.4 to 1.2% in 2026, creating room for the BoE to make monetary policy less restrictive. Furthermore, recent comments from Chancellor Reeves have provided reassurance that the government will seek to avoid making the inflation outlook worse through their choice of tax hike measures. It was a mistake last year to raise employer NICs that raised the cost of employment contributing to higher inflation and a sharp slowdown in employment growth over the last 6-12 months.

The UK government is facing the difficult challenge of attempting to restore investor confidence in the public finances while containing the negative political fallout from implementing unpopular tax hikes. Media reports at the end of last week revealed that the government has now scrapped plans to hike income tax which has cast some fresh

EUR/GBP VS. Short-term Yield Spread

Source: Bloomberg, Macrobond & MUFG GMR

doubt on their commitment to restore confidence in the public finances. It has been estimated that an income tax hike alone could have raised up to GBP10 billion of revenues. It triggered a sharp sell-off in the gilt market on Friday. 2-year and 30-year gilt yields initially rose by 8bps and 17bps respectively. The sell-off reflected unease amongst market participants that the government’s package of fiscal tightening measures without an income tax hike would be viewed as less credible undermining confidence in the government’s plans to create more fiscal headroom. The government is still reportedly set to raise their fiscal headroom target to GBP15billion from GBP10 billion. Without income tax hikes, the government will have to rely on a number of alternative revenue raising measures including potentially freezing income and National Insurance contributions thresholds from 2028-29. A greater reliance on freezing thresholds is more “back-loaded” tightening meaning the majority of the fiscal adjustment happens in the latter years of the OBR’s five-year forecast. It should help to dampen the negative impact on growth in the year ahead.    

According to media reports, the government’s decision to drop plans to hike income tax was supported by an upgrade to the OBR’s economic forecasts. The fiscal hole the government has to fill has reportedly shrunk closer to GBP20 billion down from up to GBP30 billion. If correct, it makes it easier for the government to avoid an income tax hike which would be politically unpopular and breach it’s manifesto pledge. The Labour party has already suffered a sharp decline in popularity during its first year in power including a number of embarrassing policy u-turns on welfare reform and winter fuel payments. Furthermore, the falling popularity of the Labour party is reportedly creating more unease amongst Labour MPs over the leadership of the party. Those concerns have been reinforced by recent opinion polls showing Prime Minister Starmer's public approval rating amongst the lowest ever recorded for a UK prime minister in modern British history.

In recent months it has been reported that both Manchester Mayor Andy Burnham and Health Secretary Wes Streeting have both been considering potential leadership challenges. The key test of the Labour party’s popularity will be next year’s local elections held in May. The latest media reports have even suggested that Labour MPs may not even be prepared to wait that long. To trigger a formal leadership challenge against Prime Minister Starmer under Labour Party rules, a challenger must: i) be a sitting Labour MP which currently rules out Andy Burnham from running and ii) secure nominations from at least 20% of Labour MPs. The Parliamentary Labour Party currently hold 405 seats so a challenger needs support from 81 Labour MPs. Once the leadership candidates have been selected by Labour MPs, an election is then decided by a one-member, one-vote system including Labour Party members, affiliated supporters and registered supporters.

Gilt Yield Curve Has Shifted Lower So Far In Q4

Source: Bloomberg, Macrobond & MUFG GMR

The minimum threshold for leadership candidates was raised to 20% from 10% as part of reforms in 2021 that make it harder for an outsider or grassroot candidates like former Labour leader Jeremy Corbyn to get on the ballot. It reflects a shift toward centralising candidate selection and reducing the risk of populist surges from the membership base. The current Parliamentary Labour Party is skewed more towards the centre and centre-right. It would be difficult for a left-wing Labour MP to get on the ballot which helps to reduce the risk of more disruptive left-wing policies being put in place under a new Labour leader that could trigger a bigger GBP sell-off.

We would initially expect the GBP to weaken further if a leadership challenge takes place. Market participants would move to price in a higher political risk premium to reflect unease that policy could shift more to the left under a new leader although recent reforms for rules governing Labour leadership contests have helped to reduce the risk of a left-wing candidate making it on to the ballot. In light of these political challenges for the Labour party, market participants are understandably wary that the decision to scrap plans to hike income tax was taken more for political reasons rather than prioritizing what is best for restoring confidence in the public finances.

In light of these developments, we continue to expect the GBP to underperform heading into next year. We have been forecasting (click here) a move back up to the 0.9000-level for EUR/GBP during 1H 2026. We expect the GBP to weaken further as the BoE continues to lower rates. More back-loaded fiscal tightening after excluding an income tax hike would help ease downside risks for growth in the year ahead but is unlikely on its own to prevent further BoE rate cuts. Loosening labour market conditions should continue to encourage further rate cuts. The GBP would come under more downward pressure if there was leadership challenge encouraging market participants to price in a higher political risk premium into the GBP.

At the same time, macro developments should encourage a further steepening of the gilt curve. Short-term gilt yields will be dragged lower by BoE rate cuts helping to support the long-end of the gilt curve. Declining market-based measures of inflation expectations are also helping to support long-term gilts as well. However, last week’s renewed sell-off triggered by the government’s decision to scrap an income tax hike does still highlight that long-term gilts remain sensitive to ongoing concerns over the UK’s public finances and domestic political uncertainty. Factors that are likely to remain headwinds for long-term gilts in the year ahead. Finally, we expect the Debt Management Office to stick to their current debt issuance plans that total just under GBP300 billion for FY2025/26.          

MUFG Forecasts For GBP & Gilt Yields

Source: MUFG GMR