UK Budget 2025

Of Kite Flying and Pitch Rolling

There's an old adage in sporting circles: 'win ugly' is still a win. The financial market response to Chancellor Reeves' Budget suggests that, for bond markets and for sterling, it counts as 'win ugly'. Gilts and sterling spiked modestly higher on the accidental premature release of the Budget measures by the OBR which showed that her measures doubled the headroom against her fiscal rule even without some of the more draconian measures that formed the basis of much speculation in the run up to the Budget. A tribute, perhaps, to the modern-day political sports of kite-flying and pitch-rolling.

The tax measures that were announced - the IFS (Institute for Fiscal Studies) estimates a total of £26bn, smaller than at the last Budget but another record high for the tax burden - were biased towards the later parts of the forecast period, presumably to avoid pain in the near-term (ahead of the local elections due next year) and possibly to allow time for an upside surprise to growth ahead of the next election.

But arguably the biggest structural challenge remains: almost flatlining productivity feeding into tepid GDP growth - just 1.5 per cent a year on average. Indeed, the challenge got worse with the OBR downgrading its estimates for productivity in each one of the forecast years after a surprising but welcome upgrade to the current year. There is nothing in the forecasts to suggest a productivity revolution this side of the next election.

It's the politics stupid

Party politics is of course the dog that does not bark in any Budget. This far out from the next election, a government with a big majority may be making similarly big policy changes, however unpopular. But this Labour government is riding low in the polls, nip and tuck with the Liberal Democrats and the Green Party and each of them a long way behind the populist Reform Party. On current polling, a snap election today would produce a Reform-led government - or even one where it had an overall majority.

With key local government elections due next May, the politics' spotlight shines brightly on the Chancellor's Budget. Time will tell how, if at all, she has managed to shift the dial for the political weather in the UK, and perhaps for the Prime Minister himself. Fingers will be crossed that the doubling of her fiscal headroom, according to the IFS, means she will not have to return for yet more.

Productivity - it's still a puzzle

Productivity growth is one of the two most important factors in driving GDP growth (the other is population growth). So, the OBR downgrades to its estimates for productivity growth have huge consequences throughout the headlines and detail of all other material items in this Budget.

After a welcome increase in the estimate for productivity in the current year, the OBR downgraded all forecast years by 0.3 or 0.4 percentage points. The Institute for Fiscal Studies (IFS) estimates that each 0.1 per cent decrease increases government borrowing by some £7bn, all else being equal. So, today's cuts in productivity alone add somewhere in the region of £25bn to government borrowing. And unless filled by other measures, this would increase the so-called 'black hole' by the same amount.

As we show in the later section on the Context and Background to this Budget, the UK's productivity story is not so very different to that of other western developed economies: it slumped after the Global Financial Crisis and has flatlined at that lower level for most of the intervening time.

The background is a story of low levels of investment - and the OBR does not expect today's Budget to change that sorry picture. In fact, it has downgraded its estimates for private sector investment growth in each of the forecast years; only government investment is expected to grow faster than it was forecast to do back in March.

Growth downgraded – again

Little wonder then that growth forecasts for the UK economy were also cut, although a helpful if surprising boost for the current year means the OBR expects the UK economy overall to be only modestly smaller (about 0.2%) than had been expected in the March forecast.

Nonetheless, the overall growth picture remains tepid at best: roughly 1.5 per cent annualised growth between now and the next election. Not exactly the stuff of booms. To paraphrase a fictional Star Fleet medic "it's growth Jim, but not as we hoped it would be".

Chancellor Reeves launches "counter measures"...

However small, any downgrade to the size of the UK economy is at best unhelpful to a Chancellor with very little 'headroom'. To protect her "cast iron" commitments Chancellor Reeves deployed counter-measures which, overall:

• cut departmental spending (annual managed expenditure) by some £20bn in each forecast year compared to those expected in March and

• raised taxes (mostly income and national insurance) by £55bn over the forecast period, mostly 'back-end loaded' ie the tax take increases in each year of the forecast period

...and more than doubles her fiscal headroom

One of the key measures by which the success or otherwise of this Chancellor's Budget will be judged is its overall effect on net government borrowing - now measured as PSNFL (pronounced "pea-snuffle") - as a percentage of GDP. It needs to be falling in the final year of the forecast period.

From next financial year onwards the evaluation period will change from a 5-year fixed term to a 3-year rolling one, Chancellor Reeves this time demonstrates compliance with her fiscal rule both in 2029-30 (the end of the 5-year fixed term from the time of the election) AND compliance in 2030-31 (the end of the first 3-year rolling period starting next year).

The IFS estimates that by the combination of all her measures she has more than doubled her headroom to £22bn. Fingers will be crossed that even this doubling means she will not have to return for yet more.

Background and Context

Where we are today, economically, is a result, broadly speaking, of four factors which feed into the Autumn Budget 2025 – and likely long into the future. To be fair, they have been a feature also – to varying degrees – of a number of other western developed economies.

Perhaps the key feature feeding directly into GDP numbers is the low productivity that has characterised the UK and euro area since the global financial crisis (GFC) over 15 years ago.

Since that time, and until very recently, productivity has flatlined in both regions. Since the Covid bounce, it's accelerated in most economies, but is still only some 20 per cent higher in the UK than just before the GFC. In the euro area, it's 40per cent higher over the same period. But in the USA, productivity has doubled since the GFC and grown consistently since then - no flatlining. Clearly US investments in AI and other technology will have played a major part in that acceleration.

To illustrate the significance of that difference: if UK productivity had doubled as it did in the United States then, all else being equal, the UK economy would be over 65 per cent greater in size today and the touchstone debt-to-GDP ratio would be some 40 per cent lower. There will be a similar calculation and result for the euro area, although perhaps not quite so dramatic.

The grindingly slow growth in productivity since 2010 has cost the UK and euro area economies dear.

But flatlining productivity and low trend-growth are only part of the UK Chancellor’s tricky Budget arithmetic. Another factor, upstream from productivity, is investment: here the story is, at best, sadly similar or, at worst, the UK sits at the bottom of a very big chasm.

The OECD compiles gross fixed capital formation (GFCF) as a proportion of GDP for international comparison. The UK’s performance has been relatively stable since the GFC but poor compared to peers. Since the GFC and from about 2015 onwards, the UK has recorded GFCF at around 17-18 per cent of GDP. That lags well behind US and European peers at typically 21-22 per cent – meaning they invest almost 30 per cent more in their economies annually than the United Kingdom.

Even that doesn’t explain the full global picture: China outpaces western economies by a great margin. While western economies invested 20-odd per cent or less, China was investing more than double that. Since the GFC, its investment has been above 40 per cent of GDP – at least double western counterparts – helping explain China’s more than sevenfold productivity increase compared to the UK’s 1.2 times and even the US’s two times increase.

Productivity and investment are sadly not the end of Chancellor Reeves’ challenges. The UK and other western developed economies have seen two episodes of significant increase in total government debt: the first, of course, as a result of the GFC and the second the Covid pandemic. Between 2007 and 2012, debt to GDP rose by some 36 percentage points on average - for the UK it was 40 per cent; and the Covid response added a further 20 percentage points.

Those two episodes together added an average of some 60 percentage points to government debt as a proportion of GDP – roughly half or more of the recent numbers in the USA, most major European economies and in the UK.

By conventional economic orthodoxy, those two past crises severely limit the government's options when it comes to raising finance for what may be called social infrastructure projects and for investment in physical infrastructure.

So far then Chancellor Reeves’ options in her Budget arithmetic are effectively constrained by the UK's low productivity, by its response to two previous crises - the GFC and Covid - and by a self-imposed ceiling on government debt, albeit that the UK's performance in this at least is better (lower) than most other major economies.

Which leaves the tax burden to do a lot of heavy lifting. But while headlines speak rightly of multi-decade highs, the reality is that whilst the UK's tax burden, especially since Covid, has certainly risen to multi-decade highs at around 39 per cent of GDP, that is only 10 per cent higher than its average since long before the GFC and still remains well below the averages of our European peers.

Be careful what you wish for

There is something of a feature in the UK's political economy paradigm since the GFC that seems antithetical to long-term growth. It's a paradigm which appears to have required that the increased government debt from rescuing the banks during the GFC needed to be repaid by austerity measures; and that increased debt from protecting the population against a once-in-a-century pandemic required repayment through a 10 per cent increase in the tax burden.

The net result was starkly demonstrated by Institute for Fiscal Studies (IFS) research published just before the last general election. Between 2009/10 and 2023/24, day-to-day departmental budgets were cut by 60 per cent in real terms for Housing and Communities, 40 per cent for Work and Pensions, 20 per cent in various legal departments and 10 per cent in both Defence and HMRC. Health care, including the NHS, and the Home Office, were protected departments with spending increased by 40 per cent and 20 per cent respectively. But among the rest, there were arguably cuts to the productive capacity of both departments and whole communities.

It is against that background - high debt and an increasingly high tax burden following two major crises and already deep cuts to much of the fabric of UK government and society - that Labour won the 2024 election with its mandate for change.

It's the politics stupid

But against that background and with the pledge for "Change" still ringing in the electorate's ears, it was surprising to many to see Chancellor Reeves withdraw the winter fuel allowance from pensioners and increase taxes on employers around her first two Budgets; then seek to cut benefits for some with disability and, most recently, pitch-roll the population for an income-tax increase, breaking one of her party's key election pledges.

None of which augured well ahead of the Autumn 2025 Budget. Fiscal black holes expanded and contracted; kites were flown and then cut adrift; pitches were rolled and then unrolled. The net effect - with less than two weeks to go - was confirmation that the Chancellor would not, after all, break Labour's manifesto commitments - at least not break the letter of them - regarding income tax increases.

Perhaps the change was brought about by Prime Minister Starmer's political instinct to get ahead of Reform's rising (and so far uncosted) tide of populism; or by his Chief Economic Advisor, Baroness Minouche Shafik (former Deputy Governor of the Bank of England), appointed in September, now flexing her muscles.

But by whatever prompt, suddenly we heard about better-than-expected government receipts, a productivity downgrade 'not-as-bad-as-worst-fears' and suggestions that the required 'lift' from this Budget would be to fill a hole of only some £20bn - about half the size previously speculated.

Anyone looking for an explanation may have to look no further than James Carville, one of Bill Clinton's strategists in 1992. To paraphrase him: it's the politics stupid.