UK Finance Minister Rachel Reeves Faces Deep Fiscal Challenge Amidst Austerity’s Legacy

UK Finance Minister Rachel Reeves is grappling with an unexpectedly large fiscal shortfall. Years of austerity under Conservative governments have exacerbated public financial woes. However, despite the current gloomy outlook, the situation could improve, particularly if Reeves implements planned tax increases later this year.
In her inaugural major speech since assuming office, Reeves revealed that a Treasury audit has uncovered £22 billion in unfunded commitments from the previous administration, surpassing earlier expectations. The Institute for Fiscal Studies had previously projected significant cuts to “unprotected” departments—such as Justice, Home Office, and Transport—amounting to up to £20 billion annually by 2029. The audit, however, identified substantial unfunded spending commitments for the near term. Additionally, Reeves’ decision to grant a 5.5% pay raise to public sector workers, costing £9 billion, has compounded the fiscal challenge.
To address a projected £14 billion deficit for 2024 and 2025, Reeves has canceled certain public projects and eliminated universal winter fuel payments for pensioners. She has also put a plan to build 40 new hospitals on hold. These measures are contentious due to the UK’s pressing need for new infrastructure. Nevertheless, even these tough decisions may not suffice. Reeves is anticipated to propose tax increases in her upcoming budget on October 30.
Labour has committed to raising £8.6 billion annually by 2029, while largely avoiding hikes in income and corporation taxes. Nonetheless, Reeves could consider increasing the upper rate of capital gains tax from 20% to 25% and eliminating some exemptions, potentially generating an additional £6 billion per year, according to an IFS calculator.
The fiscal outlook could improve further. A potential slowdown in the Bank of England’s sale of government bonds, starting in September, might release up to £5 billion annually, based on analysis from Forefront Advisers. This is because the BoE incurs losses on these sales, which the Treasury compensates.
Additionally, the UK’s fiscal rules require government debt to decrease as a percentage of GDP over a five-year rolling period. With the Office for Budget Responsibility (OBR) adjusting its forecast period forward by 12 months in the next budget, more fiscal flexibility could become available, as the OBR tends to incorporate tax revenues but not spending at the end of each five-year cycle.
While the OBR’s future estimates of growth and productivity could impact these gains, Reeves and Prime Minister Keir Starmer could have an opportunity to present a more optimistic economic outlook if they successfully justify tax increases.