Reeves’ impossible mission to save the public finances – in four charts
Government borrowing spiked in April, according to official data, in a stark illustration of the difficult fiscal tightrope that the Chancellor Reeves is walking.
The £20.2bn in monthly borrowing was steeper than economists’ prediction of £18bn.
So, Reeves might have shivered when she heard Keir Starmer tell the House of Commons winter fuel payments would be restored to “more pensioners” on Wednesday, knowing her fiscal rules say she cannot afford to borrow more than planned.
The £2bn cut in spending was designed as an effort to stop public finances falling apart – but the embarrassment of political backlash has ultimately scared the government more than warnings from City lenders.
Prior to the Spring Statement in March, work and pensions secretary Liz Kendall laid out government plans to get people into the workforce again and, in turn, prevent spiralling welfare bills from doing further damage to public finances.
At the Spring Statement, Reeves delivered the news that nearly £5bn cuts in welfare would be made as part of an initial package.
Speaking at the Institute for Public Policy Research (IPPR) think tank on Wednesday – just hours before Starmer announced the part-restoration of winter fuel payments – Kendall said public money had to be spent on ways that have “the best chance of improving people’s lives”.
While £5bn here and £2bn there might be meagre sums relative to the size of the UK economy and total public expenditure, the cuts can help keep Reeves’ wafer-thin fiscal headroom intact.
Labour MPs may worry that they are being perceived as cold-hearted in the eyes of UK voters. But without control over public expenditure, Reeves risks burning the trust of investors.
Reeves’ tight rules
Although Reeves’ fiscal rules, in which public finances should be in surplus or in balance on a rolling three-year target, have been slammed by former Bank of England Governor Mervyn King as “flawed”, they are designed to stop the government from becoming over-reliant on borrowing.
That forces Reeves to only consider making tax rises, spending cuts or introducing growth policies such as deregulation or pension reforms which the Office for Budget Responsibility (OBR) see as having an upside effect on GDP.
With extra spending commitments on defence, which could jump to three per cent of GDP by 2029 according to reported demands set by President Trump, and areas such as justice and healthcare due to receive fresh cash injections, hopes of a historic fall in government expenditure are fading – if they were any in the first place.
Higher levels of borrowing are only set to make one of the Chancellor’s biggest problems worse: debt interest payments.
Borrowing costs ballooning
The cost of servicing government debt has surged in the years since the pandemic, making it harder for Treasury officials who are walking a tightrope between pleasing both the City of London and the general public.
In the US, leading financial institutions are becoming more wary of the Trump administration’s tax and spending proposals, with Moody’s becoming the latest agency to downgrade the US’ credit rating.
Japanese investors are also fretting about gigantic levels of government debt and falling demand for bonds as its long-term yields surged to record highs.
With interest rate cuts set to stall given the hawkishness of the Bank of England’s Monetary Policy Committee (MPC) and the UK suffering from the knock-on effects of turmoil at some of the world’s largest economies, gilt yields could rise faster than the OBR anticipated, making borrowing costs even higher.
Reeves has not yet cast her fiscal rules aside, but tensions between Reeves and the City of London are quickly heating up.
Financiers who provide cash to the government are “in no mood to give the government the benefit of the doubt” over its failure to commit to spending cuts, according to Neil Mehta, a portfolio manager at RBC BlueBay Asset Management.
Keeping lenders onside is the most essential fight for Reeves if she wishes to keep her public finances in check.
The Autumn Budget is still around five months away, but there are no signs that day-to-day government spending will wind down given political pressures over welfare cuts.
The size of her fiscal buffer set in March is also eroding. Calculations by analysts at two of the UK’s leading economics consultancies, Oxford Economics and Capital Economics, suggest nearly half of her headroom has already been wiped out due to higher debt interest payments.
After a fall in growth during the pandemic and the introduction of the costly furlough scheme, successive Tory and Labour governments have been playing catch up by trying to narrow the gap between public spending and tax receipts.
In 2024, the margin was cut down to its narrowest level of the last 15 years but that has been coupled with the fact that the UK tax burden has reached its highest level since 1948.
Since public spending shows no signs of waning, economists have repeatedly warned that taxes are likely to go up again later this year.
Tensions with the City
Reeves’ Cabinet colleague Angela Rayner has come up with suggestions of her own, according to the Daily Telegraph, as she advised the Chancellor to tax banks, savers and the wealthy.
One of those policies includes removing inheritance tax relief for Alternative Investment Market (AIM), a sub-segment of the London Stock Exchange’s aimed at helping smaller companies grow faster.
Another involves raising the bank surcharge to five per cent, making the corporation tax rate for banks 30 per cent.
But some of these proposals would appear to go against the principle of driving higher growth, which Reeves has trumpeted as a central mission.
The Chancellor has said she is hoping to lure more investment in the UK and make it easier for banks to take risks.
Independent calculations on the risks around the exodus of former non-domiciled residents, who did not have to pay taxes on assets held abroad, serve as a warning to Reeves.
The Centre for Economics and Business Research (CEBR) said the government could make £8bn less in tax receipts this year than forecast by the OBR while the Adam Smith Institute said the UK economy would lose up to £111bn by 2035 as a result of the reforms.
Reeves’ tax raid on employers has also spooked business lobby groups including the Confederation of British Industry, with most firms claiming higher national insurance contributions (NICs) would weigh down on profit growth in various surveys.
It now seems like a long time since the winter fuel payment cut represented the government’s early eagerness to get public finances back into control.
Now the Chancellor is facing a crossroads moment and may have to decide whether she is willing to risk growth ambitions by introducing more tax-and-spend policies, or follow through with reforms to welfare.
The upcoming spending review on 11 June will be crucial for the government. It may either show Reeves is serious about kicking out quangos and putting government spending on ice, or it could inflame bubbling tensions with the City.