Tax Cuts, Rising Yields: UK Government Faces Budgetary Dilemma

The UK government is experiencing a significant increase in borrowing costs after Chancellor Rachel Reeves opted against raising income tax in the upcoming Budget. The yield on 10-year government bonds surged from 4.44% to 4.56%, highlighting market concerns over how the government will maintain its financial commitments without this tax increase. Although yields later receded slightly due to an improved forecast from the Office for Budget Responsibility (OBR), they eventually climbed back to 4.57% by Friday evening.

Initial plans to increase income tax rates by 2p while reducing National Insurance by the same amount were scrapped after the OBR provided a more favorable financial outlook. This potential policy shift was initially intended to address a £30bn gap in public finances but more recent estimates have revised that figure closer to £20bn. The decision to abandon the tax increase sent ripples through the gilt markets, especially following reports from the Financial Times.

Ruth Curtice, chief executive of the Resolution Foundation, expressed concern that the leaks around the Budget could distort market comparisons, stating that transparency in economic forecasts is necessary. Meanwhile, AJ Bell investment director Russ Mould remarked that Reeves’ rejection of tax increases may lead to doubts among bond investors about her ability to address the fiscal gap.

Economic expert Andrew Goodwin from Oxford Economics warned that the Budget represents a pivotal test of investor confidence in fiscal policies, especially if tax strategies do not align with credible assessments from the OBR. He noted that overly optimistic forecasts could lead markets to question the government’s fiscal integrity.

Despite the current uncertainties, a Treasury spokesperson affirmed that discussions around tax changes are speculative and emphasized that the Chancellor is committed to delivering a Budget that supports stable economic foundations. Both tax increases and spending cuts remain on the table as the Chancellor aims to adhere to stringent fiscal rules, particularly the vow not to borrow for day-to-day expenses and to see government debt decrease as a share of the national income by the end of the parliament.

Market analysts, like Zeina Bain from Sullivan Street Partners, noted that investors initially braced for an income tax rise, making the decision to rule it out unexpected. The overarching concern remains: how will the government fill its fiscal black hole without eroding confidence, which could lead to even higher borrowing costs?