Rachel Reeves has been warned she may have to raise income tax by as much as 4p in the pound or impose deep spending cuts to build a financial cushion ahead of next month’s Budget.
The Institute for Fiscal Studies (IFS) said the Chancellor would need to create a £50 billion “buffer” to have a better-than-even chance of meeting her own fiscal rules – which require day-to-day spending to be balanced by revenue by the end of the decade.
The influential think tank said only a large tax hike or major savings could put the public finances on a stable footing through to the next election. Anything less, it warned, would leave the Treasury “limping from one forecast to the next”.
Reeves currently has just £9.9 billion of headroom – one of the narrowest fiscal margins of the past 15 years – leaving her vulnerable to any downturn or increase in borrowing costs.
The IFS estimates she would need around 1.4% of GDP in spare capacity, or almost £50 billion, to give herself a realistic chance of avoiding further fiscal tightening later in the Parliament.
The report, part of the IFS’s annual Green Budget, said: “Whilst 1.4% of GDP is not an inconceivable amount of headroom, it would require significant spending cuts or tax rises to reach it.
“On the tax side, it would take a four percentage point increase in all rates of income tax or in the main rate of VAT.”
The Chancellor, who imposed around £40 billion in tax rises last year, has insisted there will be no repeat of that scale in the November 26 Budget.
But the IFS said that promise may prove difficult to keep as she faces what it called a “fiscal groundhog day” of repeated shortfalls and emergency adjustments.
IFS director Helen Miller said there was a “strong case” for Ms Reeves to rebuild fiscal credibility by boosting her safety margin now.
“That wouldn’t be costless – but nor is limping from one forecast to the next under constant speculation that policy will be tightened again,” she said.
Analysts at Oxford Economics and Bloomberg Economics have also urged the Chancellor to build a bigger fiscal buffer to cut borrowing costs and protect the public finances from future shocks.
But the Chancellor’s limited room for manoeuvre – exacerbated by higher debt interest payments, U-turns over welfare cuts and weaker productivity forecasts – means even a modest deterioration in economic conditions could blow her targets off course.
IFS economist Ben Zaranko said: “This is a bad place to be. The speculation and uncertainty that comes with it can be economically damaging. Policy choices got us here, and policy choices could get us out.”