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Healey faces a £35bn choice between tax rises and cuts; borrowing the difference is what the pound fears most.
Chancellor John Healey faces a £35bn choice between raising taxes and cutting public spending at the 28 October Budget, according to the Institute for Fiscal Studies, which warns that standing still is no longer an option.
The warning, published in the think tank's Green Budget on Monday, follows EY's estimate last week that the Chancellor must raise at least £12bn to repair lost headroom and fund pledges already made.
"A 'steady-as-she-goes' budget is not an option available to the chancellor," says Helen Miller, Director of the IFS.
Higher inflation from the Middle East conflict is the reason: it lifts tax receipts, but it also erodes the real value of every department's budget.
"Choosing to stay the course with the inherited tax and spending plans would mean allowing inflation to blow departments' spending plans off course. It would be a choice to tolerate chunky cuts to the quantity or quality of some public services," says Miller.
How the IFS Gets to £35bn
The headroom itself is not the problem, according to the IFS, which estimates the Chancellor could have around £20bn against his fiscal rules in 2029-30, compared with £24bn forecast in March.
Higher inflation boosts tax revenues and offsets much of the rise in borrowing costs.
The pressure sits on the spending side:
The IFS spending gap breaks down as follows:
• £12bn by 2030-31 to maintain the real value of day-to-day departmental budgets
• £3bn to protect capital investment
• Around £25bn in total to avoid real-terms cuts to departments, including plausible pay and productivity pressures
• A further £11bn to raise defence spending to 3% of GDP by 2030
That brings the bill to around £35bn, which the IFS says would require tax rises or benefit cuts on that scale.
Raising £35bn through tax alone would be equivalent to adding three percentage points to every income tax rate, or to the main rate of VAT, breaching Labour's manifesto commitments.
If the NHS keeps growing at 2.7% a year in real terms and defence plans are maintained, other departments face average real-terms cuts of 0.9% a year.
Borrowing Is the Line the Pound Watches
The IFS is explicit about the one route it rules out.
"Any significant top-up to day-to-day spending should be met through tax rises or spending cuts elsewhere, rather than increased borrowing," says the think tank.
That is also the line that matters most for sterling.
Barclays, in its UK economic outlook chapter for the Green Budget, identifies fiscal loosening at the Budget as the primary downside risk to the pound.
"The challenge is to support growth and confidence without unsettling a bond market already wary of additional borrowing," says Barclays.
The bank notes sterling has been remarkably stable on a trade-weighted basis since March, holding in a range of 84 to 86.
Gilt markets are less settled: the ten-year yield stands near 5.4%, up 0.9 percentage points since March, and Barclays notes market pricing implies a further rise to 6.2% by 2032.
Barclays' rates strategists expect hedge funds to cut their gilt positions ahead of the Budget, a sign the bond market will want the arithmetic to add up.
Defence Secretary Wes Streeting made the same connection on Sunday, refusing to commit to 3% of GDP on defence by 2030.
"If I, or the chancellor, were to sit on your programme now and say 3 per cent in 2030, without showing how we would pay for it, the markets would price in that risk, the cost of borrowing would go up," Streeting told the BBC.
Delay Versus Credibility
Our view is that the big decisions will be held back, giving the fiscal position time to improve and clearing the ground for a Spring election.
The IFS warns that this route carries a credibility cost of its own.
"Simply pencilling in implicit cuts that he has no intention of delivering would make the budget a work of fiction," says Miller.
Miller adds that Healey does not need detailed plans for the next spending review at this Budget, only overall spending envelopes he is prepared to live within.
That leaves room for a small Budget, of the kind EY described last week, provided the totals are credible.
