UK Budget: Boat-rocking averted
Yesterday’s Budget announcement was broadly in line with the expectations we laid out in our preview on Monday (see UK Budget: Don’t rock the boat). Our growth, inflation, and interest rate forecasts are unchanged. We still expect the Bank of England to hike rates at the November and February meetings. The key test was to remain credibly committed to the fiscal rules given nervous bond markets. On this measure, the UK government passed, with a muted reaction in gilt markets. Although headroom against meeting the government’s fiscal rules did decline, this was the first Budget at which the rules were tested over a more strict three year horizon (a change that previous Chancellor Rachel Reeves put into place in 2024). The government came with some piecemeal cost-of-living measures that were to a significant extent funded by targeted tax rises (see below). These will alleviate some of the pain from high energy prices, but won’t move the macro needle in our view. Perhaps the biggest surprise was the more solid commitment to meeting the 3% GDP defence spending target in 2030. This relies partly on as yet unspecified departmental capital spending cuts, and we think this will be challenging for the government to meet. The government is probably hoping that growth and revenues eventually outperform the OBR forecast. As we explained in our preview, this is not entirely unreasonable given the OBR’s very cautious wage growth assumptions (which saw only modest changes this round). Still, while the UK economy has been surprisingly resilient this year, and our base case sees that resilience continuing, such a pathway is not without risks given the elevated risk of shocks to the global economy in this volatile geopolitical environment.
Adrian Quinn
Economist Intern
Details: Headroom drops; targeted tax rises partly fund ‘breathing space’ for households
There were few surprises in John Healey’s first Budget as Chancellor. The key number was the government’s headroom against its current-budget rule. This falls to £15bn in 2029-30, before recovering to £22bn in 2030-31. The rule is therefore met, but the buffer is thin and vulnerable to further geopolitical shocks and inflation. The broader deterioration in the fiscal outlook comes mainly from higher debt-interest costs, which are now expected to be higher than forecast in March as overall borrowing has been revised up by around £18bn in 2026-27 and £16bn in 2027-28. Despite this, the OBR (Office for Budget Responsibility) projects the UK to stay on track to reduce its deficit and stabilise debt over the medium-term horizon. Although inflation has pushed borrowing costs higher in the near term, the deficit is set to fall steadily from 4.2% of GDP this year to 1.8% over the medium term.
With manifesto commitments preventing changes to main tax rates, the Chancellor opted for targeted revenue-raising measures. The most eye-catching was a temporary doubling of the bank surcharge from 3% to 6% for 15 months from January 2027, expected to raise £1.5bn. Other measures included higher taxes on property and savings income, tighter VAT enforcement for online marketplaces and higher gambling duties.
‘Breathing space’ for households was a buzz word in the Budget speech. The government extended zero VAT on domestic electricity into next summer, maintained the fuel-duty cut and announced a £2.6bn council-tax rebate for households in bands A to D. These measures provide visible relief but remain piecemeal and are too small to shift the macro outlook. This is consistent with our pre-Budget expectation of symbolic support rather than a repeat of the large interventions seen during the previous energy crisis – thus the macroeconomic impact is limited.
Defence spending goal will require unspecified cuts elsewhere
Much pre-budget speculation surrounded how Healey would address defence related spending, given his decision to step down as Defence Secretary earlier in the year because of spending concerns. The Chancellor announced yesterday that he is committed to meeting the 3% spending goal for 2030, an interim target supplementing the NATO commitment of 3.5% by 2035. To fund the governments priorities in healthcare and defence while avoiding real term cuts to unprotected departments, a top up of 11bn will be needed by 2031-32. Much rests on next Spring’s spending review for the Chancellor’s to resolve open-ended spending proposals and overcome the squeeze.
OBR forecasts look rather cautious
The OBR upgraded its 2026 growth forecast by 0.1pp to 1.2%, but downgraded its 2027 forecast by 0.6pp to 1.0% on the back of the energy shock. Higher energy prices will squeeze real incomes and domestic demand, although a softer labour market should limit the second-round effects on wages and underlying inflation. We think the OBR’s growth forecasts are on the pessimistic side and assume a sharp slowdown in growth in the latter half of 2026 and into 2027. While we also expect a slowdown on higher energy costs and rising interest rates, incoming data suggests a more modest slowdown than the OBR’s projections. At the same time, while the OBR made some modest upward adjustment to its wage growth assumptions (from 2.4% to 3.0% in 2027 and from 2.4% to 2.5% in the medium term), we still think its medium term outlook for wages is too pessimistic.