Soaring inflation could force the Chancellor to commit to more government spending, posing a worse Budget headache than a narrowing fiscal headroom, a top think tank has warned.
John Healey might have to top up department budgets by as much as £35bn by the end of the decade to stop the real-terms value of spending being eroded by rampant inflation, the Institute for Fiscal Studies (IFS) has said.
The Chancellor has been warned that soaring borrowing costs could cause his fiscal headroom to all-but vanish, though the influential City think tank has said inflation poses a bigger challenge.
The IFS has found that higher interest rates on government debt will push up borrowing by about £10bn in 2029-30, though much of this would be offset as rising inflation pushes up tax revenues.
This balancing act means Healey could face a softer fall in headroom than feared. The government’s fiscal headroom could be about £20bn in 2029-30, compared with the £24bn forecast in March, the IFS said.
The bigger issue Healey will need to face at this month’s Budget is the real-terms erosion of departmental budgets which will occur as inflation rises, the think tank said.
Healey must prove ‘credibility’
The Chancellor will have to address this issue head-on, researchers said, by either accepting real-terms cuts to public services or committing to increased spending to avoid cuts to budgets.
If he chooses to top up departments’ budgets, this could require tax rises or benefit cuts of around £35bn, according to the IFS’s forecasts.
If Healey opts to avoid this dilemma altogether, “his plan for meeting the fiscal rules will not be credible,” the think tank said.
Helen Miller, director of the IFS, said: “The Chancellor must set out overall spending envelopes that he would be genuinely prepared to live within. If he chooses the path of squeezing public spending, he should be transparent that there are tough years ahead for some public services.
“Simply pencilling in implicit cuts that he has no intention of delivering would make the Budget a work of fiction.”
The IFS’ warning to Healey’s fiscal credibility comes as the Chancellor prepares to meet finance ministers from around the world at an IMF summit in Bangkok.
Healey will seek to prove to the UK’s allies that the government is committed to getting borrowing under control, even as rising costs caused by the Iran war prompt calls for more spending on cost of living support.
In the latest warning that the Middle East conflict is hitting UK households, advisory firm BDO’s inflation index rose to 103.65 in September, its highest reading since June 2023.
Rising costs and weakening consumer confidence are hitting British firms, the consultancy has found, as its output index fell from 100.30 to 99.19 in September.
Speaking ahead of the IMF summit, Healey said: “I will work with our international partners to keep trade moving, support families and businesses, and make Britain’s economy stronger and more resilient to deliver good growth in every postcode.
“My Budget will build on this approach with fiscal discipline helping to deliver economic resilience. This means breathing space for today, and hope for the future.”