The most important month for the public finances each year is January, because that is when self-assessment receipts come in. So economists’ eyes were peeled this morning, as the January 2025 data was released, particularly as that starts to give us the real picture about how much trouble Rachel Reeves’ Budget plans are in. The answer was: bad trouble, but it could easily have been worse.
Alongside Reeves’ October 2024 Budget, the Office for Budget Responsibility (OBR) published its forecasts for the deficit. These are crucial to assessing whether Reeves’ is meeting her own (loosened) fiscal rules. The OBR had forecast that in the period from April 2024 to January 2025 the deficit would be lower than in the same period for 2023 to 2024. It actually went up, and is the fourth highest level on record, after only the Covid year and the two peak years for deficit in that period following the Great Recession.
The reason the deficit was higher than expected was not that public spending over-ran. Spending is rising over time, of course, but it was almost bang on budget in this period. Instead, what happened was that tax receipts disappointed, particularly in terms of receipts from self-assessment and receipts from corporation tax. Receipts from taxes on pay packets was actually a bit higher than forecast, because wage growth has been stronger than expected recently.
It’s worth noting that self-assessment tax revenues and corporation tax revenues will largely relate to the previous fiscal year, when the economy’s performance was already known by the OBR in October 2024. So this is a matter of the economy not producing as much tax as expected even for a known level of GDP growth. Since then, economic growth itself has disappointed. So looking ahead, we can probably expect tax receipts to disappoint even more significantly.
The widespread expectation now is that when the OBR produces its next assessment of Reeves’ fiscal plans it will say she will break her fiscal rules without spending cuts or further tax rises. Spending cuts are unrealistic, in aggregate. To be sure, Labour will find a few programmes to cut, make a big play of how tough they are being and take some political pain in implementing the cuts in those areas so as to try to signal to financial markets that they will cut spending if necessary – much as they did in the case of winter fuel payments.
But, just as in the case of winter fuel payments, that will inevitably be window-dressing for rises in total public spending. Labour MPs did not go into politics to cut overall public spending and they won’t vote for that now. Rachel Reeves’ position is already precarious enough with recent attacks on her credibility. If she sought to cut aggregate public spending she would rapidly be out. Furthermore, recent developments have suggested additional, perhaps unavoidable, pressure for spending rises, particularly on defence.
Tax rises, then? But we have seen that even the tax rises there have already been have failed to produce the additional revenues hoped. Further rises in tax rates are liable to make this problem even worse, driving the economy into recession and making the tax take fall not rise.
Simply allowing the fiscal rules to be broken could be highly problematic. We saw late last year that financial markets were not keen to fund large rises in the UK deficit, with yields on long-term government bonds rising to their highest levels since the 1990s. If Reeves abandons her fiscal rules, that could lead to yields rising even further, creating extra costs to the government of borrowing, thus making the deficit even worse.
What else is there? The Government could raise the inflation target, inflating away some of the debt. There has been talk of the inflation target being raised to 3% anyway, because a key reason for it being 2% instead of zero was that that was supposed to be high enough to avoid interest rates dropping to zero after a bad recession. Yet the experience of the 2010s implied that 2% was not enough for that.
Maybe there is a principled argument for doing this, but financial markets and the broader economy would be likely to punish the timing of an inflation rise now. It would be seen as a quasi-default – inflating away debt because the Government was too weak to take the fiscal action necessary.
Another possibility would be a fiscal crisis – a visit from the IMF and an imposed programme of spending cuts. Labour are already at 25% in the polls. Good luck with surviving as a political party if the IMF is called in.
The last option is luck. That’s what I’m betting on. New technologies such as AI might kick in just in time to boost growth enough to let Reeves struggle through. Of course, to benefit from that luck, she has to last long enough without being overwhelmed by crisis so that the higher growth has a chance to save her. Today’s numbers suggest that, even if she does survive, that could be a very close-run thing.
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