UK Budget 2026

Of kicking cans and travelling hopefully

This was always going to be a delicate exercise - a maiden budget from a new Chancellor and a new administration full of hope and ambition but constrained by caution and legacy issues. Judging by the muted reaction from the financial markets it seems that Chancellor Healey managed to navigate that terrain without triggering any of its many trip-wires. In so doing he may also have kept alive the speculation of an early general election.

The biggest changes in the economic and fiscal outlook since the Spring Statement in March were those consequent on the Iran conflict: it began just days before then Chancellor Reeves presented her policy measures and rendered almost redundant the forecasts on which her £24bn of headroom was predicated.

Budget 2026 came against the backdrop of a lull in the intensity of that same conflict but with the full force of its impact so far on energy prices and interest rates in the UK and beyond. Treading carefully the new Chancellor was able - in his own words - to provide some "breathing space" for some citizens and small businesses and some hope for the economy more generally.

Measures were introduced to ease the pain of higher energy prices and the bank levy doubled to 6% for the 15 months from 1 January 2027 to help fund them. Measures thought possible to increase revenues were not introduced: there was neither equalisation nor closer alignment of CGT and income tax; the rollback of the reduced £12,000 allowance for cash ISAs and no reduction in the "mansion tax" threshold. All had a sense of measures postponed rather than abandoned.

But, as we have noted before, a key metric for success is meeting the fiscal rules including the one requiring a measure of debt as a percentage of GDP to be falling in three years' time. Chancellor Healey achieved that. But the metric is a fragile one, relying on the small difference between two very big numbers. It will not take much of a chill wind to blow it off course with potentially painful political consequences.

That tension may feed into the speculation over an early general election. So too the next Departmental Spending Review which is due next Autumn. It's a major exercise in setting the framework for all future government spending - including increased defence commitments. It could make political as well as fiscal sense for a new administration to have its own mandate from the electorate going into that exercise.

Growth

As expected the OBR cut its GDP growth forecast for 2027 from 1.6% to 1%; hardly surprising given that its last set of forecasts (accompanying the Spring Statement in early March) were compromised even before they were delivered by the start of the Iran conflict just days beforehand. The downgrade brings it into line with more recent forecasts from the IMF and OECD.

Perhaps more surprising is the forecast rebound into 2028 driven by expected rebounds also in household and government consumption. The OBR expects higher-for-longer interest rates to be still present in 2028: bank rate around 1 percentage point higher than now at just below 5% (against 3.75% now) and gilt yields (the average across all durations) to be some half a percentage point higher also at just below 5%.

Feeding into the forecast GDP bounce in 2028 are oil-price forecasts (for Brent) which appear to assume a significant easing if not cessation in the Iran conflict eg $78 in 2027 down from $110 recently, $74 in 2028. Given the drum-beat still of conflict around not just the Straits of Hormuz but also the Red Sea oil-routes, those forecasts could prove to be the most vulnerable.

And despite the growth rebound and expected falls in the oil price the OBR expects inflation (CPI) to fall back close to the BoE target rate of 2% in 2028 - just one year later than its March forecast.

So for all of the necessarily fine crafting and tightrope walking of the Chancellor and his Treasury team, the overall growth picture remains pedestrian at best all the way out to 2031. As we have commented before, it's a long way short of a 'boom' or even of the growth rates typical before Covid.

Fiscal headroom: big numbers, small differences

Chancellor Healey was able to announce compliance with the fiscal rules including that the Treasury's chosen metric - Public Sector Net Financial Liabilities (PSNFL) as a percentage of GDP - is falling in Year 3 of the forecast. The extent of the fall in Year 3 compared to its level in Year 2 creates the so-called "headroom".

This Budget complies with the rule, creating headroom of £15bn - down from the £24bn announced at the Spring Statement but a remarkable achievement nonetheless under the intervening circumstances.

On the side of the government ledger showing its receipts, the heavy lifting - the biggest changes since March - are forecast increased Current Receipts (an additional £12bn this fiscal year rising to an additional £18+bn by 2029/30) coming mainly from increased Income Tax receipts (an additional £6bn next fiscal year rising to almost £14bn in 2030-31, to a large part fuelled by fiscal drag) and Corporation Tax receipts (roughly £7bn in each of the forecast years)

On the other side of the ledger, managed expenditure; the heavy weights are mostly the direct consequence of increased inflation and interest rates: increases in unfunded public service pensions - an additional £18bn next fiscal year compared to the March forecast, rising to an additional £20bn in 2030-31; debt interest - an additional £17bn next year but falling to an additional £12bn in 2030-31. Increased welfare spending sits somewhat further lower down the ledger at an additional £4bn next year rising to £7+bn in 2029-30.

As we have commented, the headroom - in this case £15bn - is effectively the small difference between two very large numbers: it doesn't take much in either one (GDP or PSNFL) to blow it off course: slower GDP growth; lower than expected increases in Income and Corporation Tax receipts; bigger than expected increases in unfunded pension and debt service costs.

Small differences in any of the heavy lifters or weights could make big political headaches. And those might draw attention to the fact that, while meeting the fiscal rule requiring a fall in Year 3, the levels of PSNFL (the UK's net liabilities) as a percentage of GDP are up by around a percentage point throughout the forecast compared to those before the Iran conflict.

Risks and uncertainties

There are a few:

• To be fair the OBR itself acknowledges the 'big numbers, small differences' problem we describe above and notes that "the margins against the fiscal mandate (ie the headroom) are below the average of close to £30bn held by Chancellors since 2010".

• The OBR also acknowledges the risks of escalation in the Iran conflict, saying that "if energy prices were to peak at a higher level and remain elevated for longer, we would expect increased inflation, weaker near-term GDP growth and a potential tightening of financial conditions (which) could raise borrowing by as much as £17 billion in 2027-28".

• But it is perhaps the third of its risk factors that carries the greatest structural consequence. It notes that UK productivity growth slowed after the financial crisis but its central forecast now is for a boost by some 0.2 percentage points in the medium term. That doesn't sound a lot but the OBR has previously shown that if annual productivity growth were 0.5 percentage points higher or lower, borrowing could be around £50 billion lower or £40 billion higher by 2030-31.

Background

You have to have sympathy in one major regard for the OBR and for former Chancellor Reeves: the economic forecasts from the first and the Spring Statement from the second were delivered just 2 working days after the Iran conflict began and up-ended pretty much all of the future economic framework for the UK economy. The results included feeding into the political upheaval which saw the change of Prime Minister just 4 months later on 20 July.

The first created serious challenges for fiscal policy; the second has articulated a more hopeful picture of the future for the UK and transformed the electoral chances of the governing Labour Party.

Here’s more colour on both of these issues and how they may have conditioned today’s Budget.

The Iran Conflict: hopes for rate cuts become fears for hikes

The principal factor to consign the OBR’s March forecasts to the history bin before they were published was the 180-degree flip in interest rate expectations shown in the chart above; not just for the UK but also for the USA and EU (among many others).

The chart shows the changing expectations for (3-month) interest rates in September 2027 in each jurisdiction set against the background of the changing oil price (grey bars).

The pink bar shows the expectations as they were immediately before the conflict began: a declining trend with further cuts ahead. The latest picture is transformed into expectations for rates some 1.5 percentage points higher than those just before the conflict.

Not just short rates – long-dated also

The same reversal in rates was true for longer durations also. For example, the reference duration for most calculations of present value (vital for investment decisions including for M&A) is 10-years. The yield on UK 10-year gilts rose about 1 percentage point after the conflict began. All else equal, higher 10-year yields mean lower present values and higher hurdle rates; and those mean increasing challenges for corporate actions and new investments.

Higher-for-longer cost of UK debt-service

So the outlook for UK (and other) interest rates of all durations increased with the start of the (ongoing) Iran conflict by between 1.5 percentage points for the near-term and 1 percentage point for longer-dated gilts with a similar picture in other jurisdictions also.

But for the UK Chancellor those higher interest rates across all durations add about £11bn according to the IFS - all else equal – to the cost of servicing UK sovereign debt in 2029-30 so reducing the fiscal headroom by the same amount. That’s an amount equivalent (to offset it) to increasing basic rate tax by more than 1p from 2027-2028 or higher and additional rates by 4.5p each. Politically sensitive to say the least and a major contributor to the challenges facing Chancellor Healey on his maiden outing.

The vanishing headroom

When former Chancellor Reeves sat down having delivered her Spring Statement she had created an estimated £23.6bn of surplus (headroom) against her fiscal rules. But as we said earlier, the forecasts on which that number was based were already being upended by the onset of the renewed Iran conflict.

Heading into this Budget, estimates of where the (pre-measures) headroom may be vary widely but cluster around £10-12bn, almost halved since March (see earlier for the actual outturn). The main factors in that reduction are of course the now higher-for-longer interest rates (triggering pretty much all of the lost headroom) plus their causal higher energy costs (a further £7bn reduction on some estimates). Offsetting some of those hits to the headroom are likely higher income tax receipts from inflation-driven wage increases and further reductions in net migration costs.

But as with his post Covid predecessors, Chancellor Healey is seemingly constrained by manifesto promises and Treasury orthodoxy to target the very small differences between very big numbers in establishing his headroom. Prior to Covid, and albeit on a very different basis for the fiscal rule, the March 2019 Spring Statement created headroom equivalent to 1.2% of GDP; if Healey were to aim for that percentage from this Budget he would be aiming for around £45bn of headroom, not the £15bn (0.4% of GDP) suggested by the Resolution Foundation.

It is in that gap, between the possible and the acceptable, where lies the realpolitik of modern fiscal policy.

New Prime Minister, new optimism, same fiscal challenges

The shifting sands of public opinion

The chart above shows how public opinion has shifted since June/ July in the run up to the formal change of leader for the governing Labour Party – and Prime Minister for the UK – on 20 July.

Ahead of that, the Reform Party was polling a long way ahead of the traditional two main parties: it was regularly achieving a 30+% vote share with Labour and Conservatives reduced to low 20%s. Projecting those numbers onto a General Election outcome (using the independent model from Electoral Calculus) consistently suggested that Reform could win the greatest number of parliamentary seats (MPs) although, given the vagaries of the UK’s ‘first-past-the-post’ electoral system, often without a sufficient number to form a government.

That projection has changed dramatically with what has since become known as the ‘Burnham Bounce’. Using the latest average for each party (the dotted lines in the chart above) and projecting those onto a general election outcome shows Labour as the largest party – based on current polling and the models, this would still be short of a working majority but, again using the Electoral Calculus projection, within striking distance of control, if it formed an alliance with the Liberal Democrat party.