Ahead of next week’s Budget Professor Richard McManus looks at the UK’s financial position and how much room the Chancellor has to manoeuvre if she is to maintain fiscal discipline.

Fiscal targets and headroom

If you needed to drive 50 miles, you wouldn’t put exactly 50 miles’ worth of petrol in the car. You’d add a bit more, because journeys are rarely smooth: there’s traffic, diversions, unexpected hills. Yet that is roughly how Britain is currently running its public finances.

The government’s fiscal watchdog, the Office for Budget Responsibility (OBR), thinks the Chancellor is on course to meet her main fiscal rules – balancing day-to-day spending by 2029–30 and having a broader measure of debt, public sector net financial liabilities, falling in that year. But only just. In March, Rachel Reeves had roughly £10bn of “headroom” against her main rule – about 0.3% of GDP. Historically, Chancellors have tended to leave something closer to £30bn, precisely because forecasts are uncertain and the economy never behaves exactly as expected.

That small cushion has already been eaten into. A widely expected downgrade to the UK’s productivity growth forecast could add approximately £20bn to borrowing by 2029–30. The Institute for Fiscal Studies (IFS) estimate each 0.1 percentage point cut in trend productivity raises borrowing by about £7bn in that year; markets now expect a 0.3 point downgrade. Add to this the reversals of planned welfare cuts and a series of politically driven “giveaways” and it’s easy to see why independent analysts now talk of a £30–40bn fiscal hole before the Chancellor has even started thinking about extra headroom.

In other words: we are trying to drive a long way on a tank that is already perilously close to the red.

The fiscal position

This would matter less if Britain’s debt level were low. It isn’t. With debt nearing 100% of Gross Domestic Product, small changes in the interest rate the government pays can translate into big changes in cash.

Investors in UK government debt are global savers choosing between many safe assets. If they think Britain will need to issue more debt than previously expected, or that inflation might be allowed to run higher in future to chip away at that debt, or simply that politics will make tax rises and spending restraint harder to deliver, they will want compensating for that extra risk. The compensation shows up as a higher yield on gilts.

Those higher yields then feed straight back into the public finances. The government refinances maturing debt at the new, more expensive rates and issues fresh debt to cover ongoing deficits on the same terms. Over time, the stock of debt gradually rolls over onto higher coupons. That, in turn, eats into the Chancellor’s already limited headroom, forcing talk of further tax rises or spending cuts. The more painful those future choices look, the easier it is for markets to doubt that they will ever be fully implemented, which is exactly how a risk premium becomes embedded. IFS analysis suggests that every 0.1 percentage point change in gilt rates moves medium-term debt interest by around £1bn a year.

Feedback loop

Earlier in the autumn, government borrowing costs had been drifting down. Part of that reflected global forces and changing expectations for interest rates set by the Bank of England. But part of it was home-grown. Markets had started to believe that the new Chancellor was serious about putting the public finances on a more sustainable path. Briefings about tough decisions, hints of tax rises and a generally stern tone on fiscal discipline all contributed to a sense that the UK risk premium might finally be edging lower after the dramas of recent years. In other words, credibility was doing some quiet work at the margin, shaving a little off the interest rate Britain had to pay.

The OBR’s forecast for the upcoming Budget happens to be anchored in this relatively benign period. Its rules require it to take market interest rates from a fixed window of trading days in advance of the forecast. This time, that 10-day window fell when gilt yields were relatively low and sentiment comparatively relaxed. As a result, the official projections for debt interest costs – and therefore the apparent headroom under the fiscal rules – look better than they would have if the snapshot had been taken a week or two later.

Then came the wobble. As reports emerged that a planned rise in the basic rate of income tax might be abandoned, investors took fright. The move was not enormous by historical standards, but it was sharp and clearly linked to the news. Gilt yields jumped in the space of a trading session; the pound slipped against the dollar. Commentators did not have to work hard to interpret the message: a government that balks at difficult tax decisions before the Budget has even been delivered is a government whose commitment to its fiscal strategy may be softer than advertised.

Quantitatively, that single day’s move does not transform the numbers. On standard rule-of-thumb estimates, a rise in gilt yields of a dozen basis points, if it persisted and fed through the whole curve, might add something in the low billions per year to debt interest costs by the end of the decade – irritating for the Treasury but not remotely a repeat of the mini-Budget crisis. But symbolically it is more significant. It shows how much of the earlier good news on borrowing costs was bound up with expectations of fiscal discipline, and how quickly that element can go into reverse. It also highlights how fragile the official story of improving headroom is, given that it rests on a brief interval of lower yields that markets themselves have already partly unwound.

The next crisis

My research on fiscal space suggests a simple, if politically awkward, conclusion: countries that go into downturns with plenty of room to borrow can act as shock absorbers; those that go in already stretched tend to be forced into tightening at exactly the wrong moment. Britain today is uncomfortably close to the second category. Debt is high, the interest rate on that debt is no longer negligible and the formal fiscal rules are being met by only the narrowest of margins and only under a benign set of assumptions.

’Making hay while the sun shines‘ in this context means doing the hard, unglamorous work of rebuilding fiscal space before the next crisis arrives. That implies two uncomfortable moves. First, the Chancellor should aim for more than the bare minimum required to scrape inside the rule in the final year of the forecast. A credible plan to build up a larger buffer – something closer to what previous chancellors regarded as normal – would itself be a signal to markets that short-term political temptations are not in the driving seat. Second, ministers need to be more open about the trade-offs: with weak underlying growth and rising demands on public services, there is no plausible path back to robust fiscal space that does not involve some combination of higher taxes and tighter spending.

Richard McManus is Professor of Economics in the School of Business, Law and Policing.