Rachel Reeves can’t avoid raising taxes any longer – but she’ll need to get creative | Larry Elliott

With growth weak and borrowing high, Chancellor Rachel Reeves faces significant constraints in the upcoming spending review despite pledges for increased spending in defense, infrastructure, and public services. Reeves' self-imposed fiscal rules, particularly the requirement that day-to-day spending be covered by tax receipts, limit her options and necessitate higher taxes to fulfill spending promises. While borrowing more is an option, it is unlikely outside of a major crisis, leaving Reeves to consider politically challenging tax increases, such as freezing income tax allowances or limiting pension tax relief, to avoid breaking her fiscal rules.

Analysis

The UK government, under Chancellor Rachel Reeves, faces a constrained fiscal environment characterized by weak economic growth and high borrowing, complicating ambitious spending pledges for defence, national health services, and a £15 billion investment in transport infrastructure outside London. Reeves' adherence to self-imposed fiscal rules, primarily that day-to-day spending must be covered by tax receipts and that national debt should fall as a share of national income, significantly limits her room for manoeuvre. These rules, policed by the Office for Budget Responsibility (OBR), create a strong impetus for tax increases to fund new spending commitments, as substantial additional borrowing is deemed unlikely outside of a major crisis. The political landscape is challenging, with manifesto commitments ruling out increases in VAT or income tax rates, and public sentiment, still reeling from the cost of living crisis, is hostile towards a heavier tax burden, even as taxes are projected to reach their highest share of national income in over 70 years. Consequently, the government is reportedly considering less direct revenue-raising measures, such as freezing income tax allowances or limiting pension tax relief. The situation underscores a fundamental tension between acknowledged public service needs—stemming from perceived neglect over the past 14 years—and the Treasury's affordability criteria, which critics argue may not align with the country's actual requirements and could be based on fallible OBR forecasts.

Key Decisions for Investors

• Investors should closely monitor the upcoming UK spending review and budget for specific tax measures and spending allocations, as these will likely impact various sectors and overall market sentiment amidst weak growth and high borrowing.
• Evaluate the potential repercussions of anticipated tax increases, such as freezes on income tax allowances or changes to pension tax relief, on UK consumer discretionary spending, corporate profitability, and the valuation of UK domestic assets.
• Consider the heightened fiscal policy uncertainty and the government's stringent adherence to its fiscal rules, which may limit economic stimulus, increase pressure on public finances, and potentially introduce volatility to UK gilts and sterling.
• Given the negative sentiment and cautionary outlook for UK public finances, a thorough review of UK asset exposure is warranted, with particular attention to sectors sensitive to tax adjustments and potential reductions in public spending for non-priority areas.