Reeves has made big fiscal choices but left herself little room for manoeuvre

The Labour government received an unenviable fiscal inheritance. Nearly two decades of weak economic growth since the financial crisis, coupled with rising demands on public services from the UK’s ageing population and the legacy of the pandemic had left public spending at a historically high level as a share of the economy. Meanwhile, despite the tax burden also having reached a 70-year high, borrowing remained at an unsustainable level, with debt continuing to rise.

The government’s challenge in addressing these issues was made harder by both Labour and the Conservatives being complicit in the run-up to the election in a conspiracy of silence around the true fiscal reality. The Sunak government had cut taxes in its last year in office and claimed to aspire to further tax cuts made ‘affordable’ by implausibly low spending plans. For its part, the Labour Party said it could deliver ambitious public service improvements with minimal additional tax rises and spending. This was despite the fact that we (and many others ⁴ Johnson, P, 2024, ‘What is the conspiracy of silence surrounding choices facing the next government?’, Institute for Fiscal Studies, https://ifs.org.uk/articles/what-conspiracy-silence-surrounding-choices-facing-next-government ) had spelt out the implausibility of the existing government spending plans.

Announcements since have acknowledged fiscal reality and set a new course for higher spending, tax and borrowing

In her first budget last October, Rachel Reeves faced up to the reality of the fiscal situation and made some big choices. She raised taxes by a historically large amount to pay for more spending on public services, including a large immediate spending increase. She also chose to borrow more for investment, and to broaden the measure of debt that the government targets to allow for wider use of financial transactions to boost investment even further. When the forecast deteriorated somewhat in March, Reeves reached for welfare cuts (angering backbench Labour MPs) to avoid the need for yet more tax rises or paring back of public service spending plans.

These choices have left public spending on course to stabilise at around 44% of national income – 4 percentage points higher than just six years ago (see below). Meanwhile, tax revenues are expected to rise to 37% of national income, above the roughly 33% level that has been typical in the UK for most of the period since the early 1980s. 

Reeves was keen to point to the unexpected £22bn ‘black hole’ in the public finances unearthed last summer as the reason tax rises were needed. But the truth is that most of the tough fiscal choices that this government faced were well known before the election – politicians from both main parties simply chose to ignore them.

Reeves’s second big fiscal moment came on 11 June when she set out the government’s first multi-year spending review. This provided welcome clarity to government departments over their day-to-day budgets for the next three years, and their capital budgets for the next four or more years. With the amount of money allocated at the spending review being tight – despite the spending increases announced last autumn – it required the government to make tough choices about its priorities. 

Defence was a clear winner, particularly on capital spending, following the prime minister’s announcement in the spring of a rise in defence spending. The NHS also – as usual – did relatively well, albeit not receiving as generous a settlement as it often has in the past. Other public services also fared better than they might have done on day-to-day spending. Capital spending increases were also focussed on net zero, transport and business.

Changes to the fiscal rules were welcome but have not prevented damaging fiscal ‘fine-tuning’

In the autumn, Reeves announced some welcome changes to the government’s fiscal rules and wider fiscal framework:

• Targeting the current budget balance instead of total borrowing, meaning the government can no longer simply cut planned capital spending to meet its fiscal rules, as had happened repeatedly since 2015.
• Moving to targets that bind in three, rather than five, years’ time will reduce the scope for ‘gaming’ the fiscal rules by pencilling in policies that will never happen.
• Targeting a range, rather than a point target, for the current budget deficit should reduce the incentive for constant tinkering – though this provision will only take effect in spring 2027.
• The new regular cycle of spending reviews should improve certainty around departmental budgets and reduce the scope for the government to pencil in unspecified spending cuts as a way of claiming to be on course to meet their fiscal rules.

These changes should all have improved the framework around fiscal policy making and help to counter some politically expedient but economically damaging behaviours. However this has not exactly happened in practice. 

Unfortunately Reeves has chosen to plan to meet her new rules by only a wafer-thin margin, while at the same time making a huge play of the importance of always meeting her ‘iron clad’ fiscal rules. This meant that, when the official forecast deteriorated (marginally) in the spring, she felt compelled to take significant action immediately – rushing out announcements on cuts to incapacity and disability benefits. Those hasty announcements may be about to have major political costs, as a large group of – including several high-profile – Labour backbenchers geared up to oppose the measures, forcing the government to backtrack on large parts of the cuts. 

Such a tight margin has undermined Reeves’s own mantra of stability

Reeves has rightly emphasised the importance of policy stability for economic growth. But operating with so little margin against her fiscal rules is leaving her at the mercy of events. True stability would be better enabled by restoring a larger margin and being clearer about the government’s longer-term fiscal strategy: that is, what the government’s priorities are – and why – for tax or spending, and what changes they will pursue if forecasts improve or deteriorate again.