The chancellor will need to raise taxes by £25bn if she wants to keep spending rising with national income, according to the Institute for Fiscal Studies (IFS).
In its annual ‘Green Budget’ analysis, the IFS warned that the government would have to dramatically increase the £9bn of tax rises outlined in its manifesto to meet the pressures on public services.
The chancellor is likely to stick to her fiscal rule, which requires day-to-day spending to be met by tax revenues. This means she cannot increase borrowing to fill the gap.
Rachel Reeves will present her first budget in the Commons on 30 October. Paul Johnson, director of the IFS, said this budget could be “the most consequential since at least 2010”.
The new Labour government has already pledged in its manifesto to increase government budgets by £5bn and is spending £9bn to settle public sector pay disputes.
If Labour makes no further changes to the spending envelope, which was outlined by the previous government in 2021, it would register a surplus of £17bn.
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However, those spending plans are considered wildly unrealistic and would involve real term cuts to unprotected budgets.
There is very little appetite for further cuts to public spending, so the chancellor could protect those budgets from inflation. That would leave her with a surplus of £1bn.
However, if she opted to protect spending as a share of national income – which better reflects population increase – she would record a deficit of £16bn.
That combined with the £9bn of tax rises already promised would see taxes increase by £25bn, further adding to a tax burden which is at a generational high.
It would be bigger than the net tax rises recorded in July 1997 and October 2010, which were both around £13-£14bn.
The government has also penned itself in by promising not to raise income tax and corporation tax or to increase National Insurance or VAT.
The IFS said that, even if Labour’s planned £9bn tax rise is implemented, trying to balance the current budget while avoiding cuts to public service spending would put the budget “on a knife edge” and highly sensitive to OBR judgments.
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It said the chancellor has inherited an “unenviable” public finance situation as taxes are already at a historic high and debt is rising, while public services such as prisons, police and local councils are under strain.
Mr Johnson, said: “The first budget of this new administration could be the most consequential since at least 2010… Taxes are at an all-time high, and she is tightly constrained by her pledges not to raise the main rates of income tax or corporation tax, or to increase National Insurance or VAT at all.
“The temptation then is to borrow more, perhaps changing the definition of debt targeted by the fiscal rules. But, given her pledge to balance the current budget, that would not free up additional resource for day-to-day spending.”