State of Britain’s public finances means writing is on the wall for tax rises

Rachel Reeves’s targeted deficit is £6bn higher than predicted by her budget watchdog - Jack Hill/AFP

Rachel Reeves is on course to raise taxes by at least £20bn this autumn as surging borrowing costs and public sector pay make another Budget raid inevitable.

While borrowing in July came in below City forecasts, official data showed that on an annual basis, the deficit targeted by the Chancellor was almost £6bn higher than predicted by her budget watchdog.

The shortfall has partly been driven by weaker income tax receipts and higher government spending on salaries and benefits, following the Chancellor’s humiliating about-turn on welfare reform.

Borrowing to finance the current budget deficit, which measures the shortfall between day-to-day spending and tax income, stood at £42.8bn in the first three months of the financial year, according to the Office for National Statistics (ONS).

This is £5.4bn higher than a year ago and £5.7bn more than forecast by the Office for Budget Responsibility (OBR) in March.

Economists have already warned that the £9.9bn buffer that Reeves has left herself to meet her borrowing rules has been wiped out by rising borrowing costs and expectations of higher-for-longer interest rates.

The black hole that has opened in the public finances is likely to widen in the coming months, with rising gilt yields expected to further push up Britain’s £100bn a year debt interest bill.

July is traditionally a strong month for tax receipts from the self-employed. A surge this year helped to reduce the monthly deficit to just £1.1bn last month, the lowest July borrowing in three years.

But Alex Kerr, at Capital Economics, said the July data masked a more gloomy outlook for the public finances. He said: “July’s undershoot is not as good as it looks and even if this undershoot persists, the Chancellor will probably need to raise taxes by between £17bn and £27bn at the Budget later this year.”

While headline borrowing, at £60bn so far this year, is in line with official forecasts, what matters for the Chancellor is her borrowing target. Reeves’s fiscal targets discount borrowing for investment and focus on how much is needed to fund day-to-day spending. And on that measure, she is failing.

Borrowing has been driven by higher public spending this year, thanks to surging debt interest, higher welfare payments and growing public sector pay. If the Chancellor is to miss her fiscal targets, it will be because she has failed to keep a lid on public spending.

The ONS said spending on debt interest was £41.4bn in the first three months of the year. This was 26.7pc – or more than £8bn – higher than the same period a year ago and comes against a backdrop of rising interest rates.

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Dennis Tatarkov, at KPMG, said the figures showed the “longer-term picture for public finances remains challenging, as spending pressures, especially the cost of servicing debt, continue to mount”.

He added: “While interest debt costs were below projections in today’s data, rising inflation points to increases in the cost of index-linked borrowing later this year.”

Gilt yields have risen through August, which has continued to erode the Chancellor’s wafer-thin margin to balance the current budget.

Meanwhile, the ONS said public sector pay so far this year stands at £74.4bn, up £8.5bn – or 13pc – compared with a year ago, while spending on welfare is currently running £1.4bn above forecast.

Spending is likely to keep rising over the coming year after Reeves was forced to backtrack on welfare reforms that were planned to take effect in 2026.

The Chancellor must now find £5bn in tax rises or spending cuts to cover the about-turn on welfare, as well as a decision to restore winter fuel payments of up to £300 for most pensioners.

Welfare spending could yet rise further. The annual uprating in benefits is usually pegged to September’s rate of inflation, which is currently forecast to peak at 4pc by the Bank of England.

Elliott Jordan-Doak, at Pantheon Macroeconomics, said the “litany of policy U-turns” had only “compounded the Government’s fiscal woes”.

Tax receipts, while strong in July, have also disappointed so far this year. Income tax receipts, which account for £1 of every £4 that flows into the Treasury, are currently running £1.4bn below official forecasts.

The OBR will have to make a judgment in the autumn about whether this slight underperformance is likely to continue. If it concludes that the answer is yes, it means Reeves is unlikely to get as much as she hoped – another blow.

Disappointing income tax receipts have so far been mostly offset by a rise in National Insurance contributions following the Chancellor’s £25bn tax raid last October. “Compulsory social contributions”, as the ONS terms it, increase by £9.5bn to £63.8bn.

Ultimately, however, any shortfall in tax receipts would be dwarfed by the impact of a possible OBR downgrade to the UK’s long-term growth prospects and productivity. Economists have said that downgrades from the over-optimistic OBR are overdue.2208 Government borrowing is close to forecast

Whatever happens, economists believe more tax rises are on the way. The National Institute of Economic and Social Research (Niesr) has warned that Reeves faces a black hole of up to £50bn. The Chancellor is now examining increases to both inheritance and property taxes as a result.

Martin Beck, at WPI Strategy, said Thursday’s borrowing figures suggested Niesr’s estimate was wide of the mark, but added that he still expects tax hikes this autumn.

He said: “The Chancellor’s decision to leave herself with just a £10bn buffer against her main fiscal rule was always a high-stakes gamble. That cushion is probably shrinking, so tax rises this autumn still look likely.”

Doak added that the public finances remained “chronically weak”.

He said: “We think the Chancellor will need to resort to ‘sin’ and ‘stealth’ tax hikes, duty increases, and a pensions tax raid in order to meet her fiscal rules if she wants to meet her pledge of keeping headline tax rates unchanged.

“We expect the bulk of those tax hikes to be backloaded towards the end of the forecast period, minimising any short-term growth implications. But that will buy the Chancellor only precious little time. The public finances are unsustainable in the long run and delaying action now increases the risks of needing to make sharper adjustments in the future, which would be more disruptive for economic activity.”

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