Rachel Reeves Seeks Budget Headroom to Safeguard UK Economy Amid Bond Market Volatility

Rachel Reeves is aiming to create more “headroom” against her fiscal rules in November’s tax-raising budget, a strategic move designed to cushion the UK economy against volatile government bond markets.

The Chancellor successfully met her initial fiscal rule – to balance taxes and day-to-day spending – with a £10bn margin in last autumn’s budget and again in her March spring statement. However, this historically narrow margin has consistently left Reeves vulnerable to breaching her rules, particularly as market pressures drive up the cost of government borrowing.

Reeves hopes that by accumulating a larger fiscal buffer, she can dampen the incessant speculation surrounding potential breaches of the rules in the Office for Budget Responsibility (OBR)’s upcoming forecast, and influence how the government is perceived to respond.

“We would like more headroom. We want to try to insulate ourselves better against the volatility in the bond markets,” a Treasury source stated, confirming that both tax increases and spending cuts are under consideration.

However, with Labour currently trailing in the polls, ministers are acutely aware that another significant money-raising budget, following last year’s £40bn-a-year tax-raising package, will be a difficult sell to voters.

Ruth Curtice, director of the Resolution Foundation thinktank, commented: “The chancellor is right to try and increase the margin for error against the fiscal rules. Doing so could have big rewards, not least in reducing the chances of having to come back for a third round of tax rises next year.” She cautioned that typical forecast variations of £17bn make a margin of under £10bn particularly slim during times of heightened global uncertainty, making the task of increasing this buffer a daunting one.

A recent downgrade in the OBR’s productivity forecasts, which points to a weaker outlook for economic growth, is already projected to have pushed Reeves £10bn-£20bn a year off course since the spring statement. This is compounded by a further £6bn-a-year gap from the cost of reversing cuts to the winter fuel allowance and the welfare changes opposed by Labour backbenchers. Any desired increase in headroom would need to address these shortfalls first.

Navigating Tax Policies and Long-Term Pressures

Despite the challenges, Reeves has rejected calls from some within her party to breach Labour’s manifesto pledges on the main rates of income tax, national insurance, and VAT – taxes that collectively account for about 75% of government revenue. Instead, she is developing a package of tax-raising policies designed to address existing distortions within the system.

Measures reportedly under consideration include charging national insurance on landlords’ rental income, further reforms to capital gains tax, and an increase in taxes on gambling, a proposal advocated by former Chancellor and Prime Minister Gordon Brown.

Treasury sources also indicated that the budget would “face into” longer-term pressures on tax and spending. The OBR recently highlighted the unsustainable nature of the public finances in the long term, pointing to the soaring costs of the pensions triple lock and declining petrol tax revenues as drivers switch to electric vehicles. Labour has committed to maintaining the triple lock for the duration of this parliament and has excluded it from the independent pensions commission’s remit, but has made no commitments beyond the next general election.

The Treasury anticipates that a decisive package of tax and spending measures in the upcoming budget will bolster bond investors’ confidence, potentially leading to lower government borrowing costs.

Economic Outlook and Market Sentiment

David Gauke, former Conservative chief secretary to the Treasury, suggested that Reeves could win over bond investors by building up significantly larger headroom, perhaps £20bn-£30bn, but cautioned about the immense political difficulty of such a move. “This is still early in the parliament. If you can successfully land it, then you do find yourself in a virtuous circle with the markets,” he noted, adding that given the scale of tax increases required, “It would be a big leap into an icy pool of water and you don’t know if you’re going to be out of your depth.”

The government currently spends £110bn annually on interest costs alone, making even minor market shifts financially significant. While Treasury sources attribute rising yields on 10-year UK government bonds, or gilts (which have climbed from 4.2% to 4.7% since Labour took power), to global instability like the French budget crisis, analysts also highlight the precarious state of the UK’s public finances, characterized by weak growth and increasing spending demands.

Helen Miller, director of the Institute for Fiscal Studies, emphasized the need for greater stability: “Adjusting policy twice a year in response to run-of-the-mill forecast changes is not a sensible place to be in. The problem is not caused by the OBR, or by the number of fiscal forecasts, but by the chancellor’s decision to operate with tiny headroom against pass-fail fiscal rules. A clear way to break out of this cycle would be to use the upcoming budget to build a larger amount of fiscal headroom.”

Andrew Goodwin, chief UK economist at Oxford Economics, concluded: “Markets are concerned about the fragility of the UK fiscal outlook.” He warned that while markets are currently giving the UK the benefit of the doubt, “sentiment could turn rapidly, particularly if the government missteps.”