Tax hikes put UK budget deficit on track against official forecasts

UK public sector borrowing for May totaled £17.686 billion, slightly above forecasts, but overall borrowing for the first two months of fiscal year 2025/26 is below the Office for Budget Responsibility's predictions due to increased business tax payments; this offers some relief for Finance Minister Rachel Reeves, though her budget plans remain vulnerable to economic headwinds, including geopolitical tensions and weak business confidence, and the ONS warned that next month’s data was likely to show a "very high" debt interest payment.

Analysis

UK public sector borrowing in May 2025 reached £17.686 billion, slightly exceeding the median economist forecast, though cumulative borrowing for the first two months of the fiscal year at £37.7 billion remained below the Office for Budget Responsibility's (OBR) £40.7 billion projection. This better-than-anticipated start is primarily attributed to an influx of business tax payments, notably a 17.5% year-over-year surge in social security contributions for April and May combined to £30.2 billion, following an April increase in employer National Insurance Contributions. While this offers some temporary relief for Finance Minister Rachel Reeves' budget, which operates with a minimal fiscal buffer equivalent to less than 1% of annual spending, significant underlying economic weaknesses and looming fiscal pressures temper this positive signal. The Bank of England has highlighted a weak underlying pace of economic growth, British retail sales volumes recorded their sharpest drop since December 2023 last month, and an ONS statistician warned of a likely 'very high' debt interest payment in the upcoming data release due to inflation-linked bond servicing. These domestic concerns are compounded by external risks such as potential Middle East conflict, surging oil prices, subdued business confidence following tax hikes, and global trade tensions, contributing to increased volatility in the British government bond market and reinforcing a cautious outlook, as characterized by the ICAEW's assessment of the borrowing figures as a 'lonely amber light' among many 'red lights' on the government’s economic and fiscal dashboard.

Key Decisions for Investors

• Investors should acknowledge the short-term improvement in UK public finances due to higher tax receipts but remain cautious given the narrow fiscal headroom, weak underlying economic growth highlighted by the Bank of England, and the recent sharp decline in retail sales data.
• Close monitoring of upcoming UK inflation figures and the subsequent June debt interest payment data is crucial, as these releases are anticipated by the ONS to be significant and could exacerbate volatility in the UK government bond market and influence sentiment towards UK assets.
• Given the persistent economic headwinds, potential for rising debt service costs, and noted bond market volatility, consideration should be given to reviewing exposures to UK gilts and sterling, and exploring strategies to hedge against potential fiscal deterioration or sustained inflation.