Britain at breaking point: why it’s time for a fiscal reckoning
Our Senior Consultant Economist, Matt Latham shares his thoughts on the critical fiscal challenges facing Britain today and why urgent action is needed to prevent further decline.
Spare a thought for Rachel Reeves, the Chancellor has a serious trilemma:
She was already treading water to keep up with spending commitments to protected departments (education and health), as well as to big expenditure items like the triple lock and our eye-watering debt repayments.
To add to her woes, last month the PM put the UK on a ‘warfooting’ - with a fresh commitment to urgently increase defence spending to 2.5% of GDP by 2027, with ambitions to bring it to 3% in the next parliament.
She continues to bind herself to her own fiscal rules (important to reassure the bond markets which have already had a wobble under her watch).
If it were the early noughties and the UK’s economic conditions were thriving, these challenges might not be so difficult.
But alas we’re not. We’re through the looking glass. Welcome to the UK 2025 in what some economists (me) are calling the “Britain’s bin fire” era. Here are some top highlights:
Growth? Anemic.
Business confidence? Almost non-existent.
Productivity? On the floor.
Taxation? The highest since at least WW2.
Pensions? Ever more expensive.
Public sector debt? £2.7 trillion (or 96% of GDP)
6 million on out of work benefits, almost doubled from 3.5m in 2016 and due to rise to 8 million in a few years.
Simply put, the country is broke.
This means, the amount of ‘headroom’ Reeves has to meet her ever growing list of commitments is tiny. And it seems to be diminishing by the hour. What can she do about it?
The OBR’s scary forecast
Last Autumn, the OBR’s projections of what ‘business as usual’ means for the UK are genuinely quite shocking.
Without any fundamental changes to how the government taxes and spends, expenditures are set to grow from 45% of GDP today to over 60% of GDP by the back end of the century. This is largely driven by our aging population straining our health and pension systems, coupled with a poor outlook for growth.
This increased spending pressure isn’t expected to be accompanied by any improved ability to bring in revenues. As a result, the OBR predicts that the UK’s debts “would rise rapidly from the late 2030s to 274% of GDP” during the latter half of the century.
You may want to sit down and read that figure again: Two-hundred-and-seventy-four-per-cent of GDP (currently we are at 96%). That is, of course, if the bond market would allow so much borrowing - which they wouldn’t.
Figure 1: real and projected total government expenditure and revenues, as per the OBR’s fiscal risks and sustainability report (September 2024)
A reckoning approaches
For the last decade or so, government’s default option to deal with increasing fiscal pressure has been:
Cut spending on unprotected budgets (an Osborne classic). ‘Unprotected’ budgets essentially include everything which isn’t the NHS or schools - serious things like our police, prisons, child protection and social care.
Allow the tax burden to sneak up, mainly by freezing or lowering thresholds (a ‘Sunak special’ in the early 2020s)
The result of these tactics means today’s tax burden is not only at its highest since the close of World War II, but the budgets of unprotected government departments are now at 11% of current spending (down from over 20% in 2009/10).
It’s clear that this set of tactics can’t be applied forever. With the trajectory set out above, even were we to cut unprotected spending close to zero (an insane idea), it likely wouldn’t cover the spiralling costs of paying for an ageing population or our spiralling debts.
At some point a reckoning has to be made that - with an ageing population and flatlining economy - we can no longer make good on all of our current fiscal commitments.
This has been true for a number of years.
But the political difficulty of communicating the scale of these problems - and the fact that there will be real losers no matter which path we choose - has meant that the more expedient ‘default option’ is the path that multiple governments have chosen.
The additional pressure of rapidly increasing defence spending now has the potential to force this issue up the agenda. There’s really no room to hide anymore.
What the rise in defence spending means for the public purse
Bradshaw Advisory’s modelling, based on OBR forecasts and the spending plans outlined in the Autumn Budget, suggests that were the government to bring defence spending to 2.5% of GDP in 2027, it would be forecast to have a £6.4bn deficit that year, a major turnaround compared to the £9.5bn surplus forecast by the OBR in the autumn. That’s even when we account for the extra £6bn coming from cuts to overseas development assistance, which the government hopes will plug much of the defence funding gap.
Note that these figures are based on the OBR’s autumn projections. With incoming growth downgrades, the forecast for the deficit will only worsen.
This doesn’t necessarily mean that the move would break the chancellor’s fiscal rules. For decisions made this year, the chancellor would need to be on track for a balanced budget in 2029/30 to be in the clear with the OBR.
Our modelling also shows that if the government wanted to meet its ambitions of increasing defence spending to 3% of GDP in the next parliament, the deficit could increase to £9.4bn in 2029/30 - a £19.5bn difference with what was forecast at the autumn budget.
For unprotected departments such as the DfT and DCMS, this would mean absolutely no growth in their budgets in real terms between 2023/24 and 2029/30.
If these cuts were spread evenly across unprotected departments, we would expect real-terms reductions for the single intelligence account, the FCDO, DCMS, the DfT, DEFRA, HMRC and the Treasury (see table 1). Under evenly spread cuts, we could see HMRC’s budget shrinking by 13% in real terms by the end of the decade. The impact of the overseas aid cuts would see the FCDO’s spending power reduced to a shadow of its former self.
These cuts are the minimum required for the government to just scrape passing their first fiscal rule without additional increases in taxation. Were the chancellor wanting to aim for getting the country back on the same trajectory we were predicted to be on at the Autumn Budget, which still appeared precarious by any measure, many more billions in cuts or tax increases would be necessary.
Table 1: real changes to departmental revenue expenditures between 2023/24 and 2029/30, compatible with defence ambitions, cuts fall evenly across departments.
This, of course, is not the first time these departments have faced serious real terms cuts. As noted above, these unprotected departments saw their budgets reduced from making up 20% of current spending in 2009/10 to 13% in 2023/24, with some of the most serious cuts landing on local government.
Figure 2: real changes to Departmental Expenditure Limits 2009/10 to 2014/15 (selected departments)
Were the government to go ahead with their ambitions with defence - AND keep to both their fiscal rules and commitments to protected departmental budgets - we could well see the continuation of a trend where unprotected departments’ budgets continue to shrink to only making up 6% of spending by the end of the decade. Note that they made up over 20% of current spending in 2009/10.
Figure 3: makeup of current spending in 2029/30 consistent with government defence ambitions and fiscal rules being met.
Can we really go on like this?
The reality is that ‘business as usual’ within the UK’s current fiscal regime is no longer tenable.
Unless the increasing impossibility of keeping to our heavier defence commitments, fiscal rules, departmental protections and commitments to expenses like the triple lock, is acknowledged the outcomes will be ever more serious.
State capacity in unprotected, but still vital areas, like transport will decline rapidly. The tax burden will inevitably grow even past its current record levels, putting both businesses and workers under increased strain. This will no doubt raise more concerns around the country’s reputation as a place to do business, putting further dents in the country’s outlook for growth. This is all in a context, where our growth forecasts are already being cut, which will undoubtedly shrink the fiscal headroom available even further.
What’s more, the measures highlighted above would only be enough to cover the cost of increases in defence spending. The cost of responding to the country’s changing demographics over the coming decades is another matter entirely.
So what should we do about all this?
As a first and obvious step, communications about the real state of the public finances need to change. Our major political parties must be willing to tell the public that we cannot have our cake and eat it. The default option of cutting unprotected budgets and letting the tax burden sneak its way up was never the have your cake and eat it option - it was just another unpleasant option which was more palatable in the short term.
The second step is choosing which of our long list of commitments is to be rolled back. There is no right answer to this and all choices will no doubt have their losers. Tweaking the fiscal rules (again) could provide some greater short-term flexibility, but extreme caution should be taken to avoid a punishment on the bond markets.
On the spending side, the triple lock should very clearly come under serious scrutiny, as could many of the subsidies offered through the pension system. Tax reliefs offered on contributions, for example, disproportionately favour high earners. These stand as huge expenses and ones which are unlikely to be sustainable as the UK’s demographics decline further, but they also stand as some of the most politically difficult to stomach.
This week’s Spring Statement is a fiscal event in all but name. Here we will see how the chancellor balances priorities on spending and protecting public services.
Leaked civil service conversations suggest that mooted cuts of 7% on unprotected departments could have serious consequences for public services, including prisons and the delivery of frontline policing. For the path ahead, these cuts would likely have damaging political consequences for a government desperate to avoid ‘austerity.’
We could see pushes to increase taxes in some areas. But commitments to ‘not increase taxes on working people’ would likely limit the revenues which could be brought in. Further increases in the tax burden for business would only add to the criticism from the private sector sparked in the autumn.
The UK’s fiscal reckoning is not a question of if, but when. All paths out of this will have their losers, with the government’s reputation all but guaranteed to be one of the things taking a hit in any and all circumstances. The longer we delay hard decisions, however, the fewer choices we will have left - and the more painful they will be.