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Warnings about a “painful” budget tend to mean big tax increases are imminent.
Chancellor Rachel Reeves says she must find £22bn to fix a “black hole” in the public finances.
At the same time, she pledges to end austerity and spend money on areas such as hospitals and roads, which are key to boosting growth.
So how can it achieve both without sharply raising taxes?
Reeves is expected to have a trick up his sleeve.
It centers on self-imposed borrowing limits by the government. This hack won't eliminate tax hikes – but could limit their scale.
Why do we need borrowing rules?
In the UK, the government has decided to stick to the current fiscal rule that debt – the total amount owed by the government – must fall in five years.
Almost all rich countries have some form of these rules in place, in order to maintain their credibility with financial markets and taxpayers.
This is crucial. In nine out of ten years the UK ran a deficit – the difference between money coming in and going out – with the shortfall usually made up by borrowing from those markets. The less credible the rules or plans to comply with them, the higher the borrowing costs.
Liz Truss' 2022 mini-budget is a prime example of the price of losing credibility. His failure to provide plans for how his government would finance the biggest tax cuts in half a century, and the lack of independent review of those plans, has caused borrowing costs to skyrocket. The same goes for the cost of new fixed rate mortgage transactions – which are also linked to these markets.
Rachel Reeves' Debt Hack
The chancellor sets his own rules. However, it is up to the independent Office for Budgetary Responsibility (OBR) to do its homework and assess the impact on public finances.
Before the general election, Reeves said she would largely replicate the rules set by her predecessor Jeremy Hunt. At the time of its March budget, the OBR predicted it would follow the rules with very little money to spend.
Reeves should avoid some of this pressure by changing the definition of debt. There are many options.
The first is to change the way the Bank of England's operations are handled. During the pandemic, the Bank injected funds into the system by purchasing long-term investments called bonds to stimulate the economy. By reselling them, it incurs losses due to rising interest rates.
A different definition of debt, which treats these losses differently or omits them altogether, could allow the Chancellor to claim that the debt will fall more quickly in five years than under the current measure, giving her at least £16 billion more sterling to spend.
It could also take a different approach to the public accounts, to put more value on what the UK has rather than just counting the money that comes in and goes out.
Public sector net financial liability is a broader measure, including, for example, the money the government receives from people repaying their student loans, which could give Reeves £50 billion more to spend.
An even broader measure, public sector net worth, incorporates estimates of the value of infrastructure such as buildings and transportation. This could mean a little more room to maneuver – but it's particularly difficult to measure.
Window dressing, tax rigging and a masterclass in creative public accounting? The Conservatives have already expressed certain concerns.
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Rachel Reeves will present her first budget on October 30
I don't intend to spend it all at once
All of these debt measures have advantages and disadvantages. And whoever gives the most favorable answer today may not be so next year. But all of them are already published and economists are pretty relaxed about which one is used.
But what about those borrowing costs? Out of every £12 spent by the government, £1 goes towards paying interest on existing debt.
Amid growing expectations that it will seek to borrow billions more in financial markets, the cost of new borrowing is already rising, affecting fixed-rate mortgage deals.
However, analysts say the increases should be limited as investors are inclined to put more money into the system.
And Reeves won't spend all the money available. Credibility relies on appearing prudent, and she said she was not in a “race for money down the drain.”
Additionally, the vast majority of any additional spending authorized by a rule adjustment will be allocated to investment or capital expenditures, including on school buildings and roads.
Because Reeves is committed to respecting a second crucial rule: the government will finance all daily expenses with tax receipts.
Investment projects, if done wisely, create value for future generations and are recognized by economists and investors as essential to stimulating growth.
As things stand, investment spending is expected to decline relative to the size of the economy. Restoring this situation would require around £20 billion more.
To try to keep markets calm, Reeves promised to limit the pace and scale of capital spending.
Yet this leaves a multi-billion pound problem to resolve. Under current plans, many utilities are facing reduced budgets for day-to-day spending.
Mitigating this and meeting other priorities in the government's agenda is likely to involve tax rises of up to £25 billion, according to the Institute for Fiscal Studies. The Labor government hopes to raise £9 billion from the measures included in its package, but the rest has not yet been specified.
Even with changes to the fiscal rules, there will be winners and losers, determined by the chancellor. The rest of us may have to wait until October 30 to find out which camp we belong to.
