UK Budget Preview: One month to go

As we have 20 days until Chancellor Reeves announces her first tax and spend decisions the focus is on the change to the government’s fiscal rules, which could unlock £57bn for investment in the UK. These changes include removing BOE transfers from the UK balance sheet, and changing the way that investment is looked at in the Budget. Public sector net worth (the value of the governments investments including the student loan book and the motorway network) could be subtracted from what the government owes, to unlock billions more for investment.

The bad news is that the Institute for Fiscal Studies says that the UK will have to raise £25bn in taxes to meet the government’s spending targets. This could increase the chance of more austerity in the budget, or some unpopular tax increases. When it comes to the UK’s government finances, nothing is simple. The government may give to the public in public services, but the chances are high that it will take away with tax increases. The government remains committed to allowing oversight of her plans from the OBR and she is likely to remain committed to funding everyday spending and debt interest payments with tax receipts. Thus, the Budget changes are causing more of a storm in the media, and not in financial markets. UK bond yields are moving with global trends, and we do not expect a Truss style market shock on the back of the Budget later this month.

No Truss-style bond market blow up from Reeves 

Usually in the lead up to the Budget, the details are leaked, so it is rare that there is a shock for financial markets. This was not the case in 2022, when Liz Truss and Kwasi Kwarteng’s budget plans for large unfunded tax cuts sent the UK bond market into meltdown. However, the lessons from the Truss era appear to have been learnt, and we expect the Chancellor to lay out a message that is finely tuned to avoid spooking financial markets. 

Doom and Gloom message ahead of Budget 

Ahead of this Budget, the focus has been on fiscal black holes and potential tax increases and spending cuts, most notably the cut to the winter fuel allowance for pensioners. ‘Good news’ from this Budget has been in short supply, which has led to accusations that Rachel Reeves and Sir Kier Starmer are talking down the UK economy. They have been accused of over-stating a £22bn fiscal blackhole, and there have been complaints from business heads along with the OECD, that the government should avoid draconian spending cuts.  

UK’s economy provides a pleasant surprise ahead of Budget 

The initial message from Chancellor Reeves, that the UK’s economy was worse than she thought, weighed on consumer and business confidence. The Lloyds Business Barometer has slipped since Labour won power, and the GFK consumer confidence indicator has fallen sharply since August. Reeves’ argument about the dreadful legacy that she inherited is also coming apart after the OECD revised up the UK’s growth outlook for 2024. The UK economy is expected to grow by 1.1% this year, the same rate as Canada and France, and behind only the US. Growth for 2025 is also expected to be robust, as the OECD dramatically upgraded their outlook for UK growth. 

Surprise giveaways to sweeten Reeves’ sour message 

In the coming weeks, we expect to get more details of what to expect in the Budget. The backlash against Reeves’ initial doom and gloom message means that we may get a few hints on Budget sweeteners that may be coming our way to counteract some of the initial sourness in her message. Below we look at potential changes to tax policies, spending plans and fiscal rules, which are likely to dominate this Budget. 

Tax policies

Increases in tax have been a key message from the government since it took office. The Chancellor’s repeated reference to the £22bn black hole in the UK finances, were seen as prepping markets for a raft of tax increases. Already the government has announced that it will apply VAT on private school fees from the start of the year.  

Council tax could also be changed, with a re-valuation of properties included in the Budget. This could push up council tax for millions of homeowners who have seen their houses surge in value since they bought them. A change in council tax is preferable than a wealth tax for many UK consumers, however, it could further dent consumer confidence. It may also hurt the housing market and estate agents may take a hit, as it could put people off upscaling in the future. 

Private equity is also in the cross hairs of this government. The government has already announced plans to reform the taxation of carried interest, however the details have been limited. The P/E industry has put pressure on the government to provide evidence of the effect of their planned reforms before implementing them. However, any change to carried interest in this Budget is unlikely to have a broad effect on UK asset prices, and instead it may hurt individual names with big P/E arms. 

Non-doms and their tax status in the UK, have been a contentious issue leading up to this Budget. The government published proposals to abolish the UK’s special tax regime for non-domiciled residents of the UK back in July. This included potentially taxing the inheritance of these individuals, even if business interests and funds are held offshore. However, Treasury officials have reportedly told the Prime Minister that any changes to the non-dom policy will fail to raise any money, as super rich non-doms living in the UK may simply move abroad. This could end up costing the UK up to £1bn in revenue. Thus, it is uncertain at this stage whether Reeves will press ahead with this plan, and there have been reports that it could be shelved or watered down. If the UK is seen as being hostile to wealthy foreigners, it could take the shine off UK assets, especially UK stock indices, although we think that would be a chronic problem, and we would not expect it to lead to a sell off in the short term. 

Inheritance tax changes are highly likely in this Budget. This could include removing the inheritance tax for residuary pension funds after the pensioner dies. It could also include introducing progressive IHT tax bands, potentially peaking at 50% for the largest inherited estates. 

Pension tax relief changes could also be a big winner for the Chancellor if she needs to fill any fiscal holes. The total cost of tax relief on pensions in the UK is thought to be £50bn per year. Some of the reforms to pension tax relief include cutting income tax relief on pension contributions and imposing national insurance on employers’ contributions to employee pension schemes. These measures could generate much needed cash for the Treasury, and we expect changes to pension tax relief to be a centre-point of the UK’s Budget. 

Investors are also gearing up for increases in capital gains tax. Some of the changes that the government may consider include taxing all capital gains at income tax rates, or charging capital gains tax to one flat rate that is below the top rate of tax, but higher than where it is today. If there is only a small change in CGT then we doubt that it will have a long-term impact on UK stock prices, however, a drastic change could lead to a sell off in UK equities. As you can see, the UK’s FTSE 100 index has underperformed its European and US peers over the past year, and there is a potential that the Budget exacerbates this situation further. 

Chart 1: FTSE 100 vs. S&P 500 and Eurostoxx Index, normalized to show how they have moved together in the last 12 months. 

Past performance is not a reliable indicator of future results.

Source: XTB and Bloomberg 

The government has ruled out changing the main rates of tax including National Insurance, income tax and corporation tax. Any changes to these rates would have the biggest market impact. However, investors will still be watching the budget closely, as the UK’s tax burden hit 35.3% in the last fiscal year, which is the highest level on record. If the government is focused on growth, then investors will also be looking for Reeves to lay out how her government will reduce this burden, spur investment and boost government income through higher levels of productivity and economic growth. 

Spending plans

Ahead of this Budget, the focus has mostly been on spending cuts, and the contentious cut to the winter fuel allowance for pensioners. The Chancellor is planning to scrap this payout for all but the neediest pensioners. Although it has come up against fierce criticism, the Chancellor is standing firm, and we expect the cut to this allowance to be included in the Budget. 

Other announcements of big spending plans have been few and far between, for example, how to fund the ever-growing NHS Budget. Also, the PM has been clear that he wants to get people back to work, there has been an increase of nearly 1 million people on long-term sickness benefit in the UK since 2019. This was exacerbated by the pandemic and is particularly acute in young men. We expect changes to welfare spending in this Budget, which has ballooned in recent years and is a threat to the long-term fiscal health of the nation. At the same time as the government tries to reduce the welfare bill, it may also boost the minimum wage, to encourage people back to work. 

One of the most important elements of this month’s Budget will be the government’s industrial strategy for the next 10 years. However, don’t expect a detailed plan to be delivered by the Chancellor on 30th October. Instead, she is likely to mention some of the key headlines from her strategy. A green paper is likely to be published around the time of the Budget, with a full strategy document due in 2025. This will include detailed plans for the National Wealth Fund, which is likely to be used to fund investments in the steel industry, ports, battery factories, and green tech projects to help with the UK’s transition to net zero. The market is hungry for details about the plans for UK industry. If the mood music is positive about this industrial strategy and its potential to boost UK growth, then this could be good news for the pound. Sterling is the best performing currency in the G10 so far this year, and the upside surprise to growth and the improving outlook is no doubt one of the reasons for this. Thus, a positive reaction to the Chancellor’s growth plan could be mildly pound positive. 

Chart 2: GBP vs. other G10 currencies so far this year 

Past performance is not a reliable indicator of future results.

Source: XTB and Bloomberg 

Fiscal Rules

There is rising expectation that Chancellor Reeves could change how the government’s fiscal rules are calculated to allow more spending on housing, roads and hospitals. The Labour government has promised that it would follow the Conservative’s fiscal rule, that public sector net debt should be falling in the fifth year of a forecast period. One way that the Chancellor could achieve this fiscal target at the same time as boosting investment, is to exclude losses on the Bank of England’s stock of bonds from quantitative easing from the government’s balance sheet. This could give the Chancellor up to £15bn of fiscal headroom. 

Other plans being discussed include moving a national wealth fund away from the government’s books, which may also add another £15bn to the Chancellor’s fiscal headroom. The government is looking at ways to publish estimates of how much new capital projects will boost growth and generate money directly for the Treasury, which could also take the focus away from capital spending. 

Two years ago, the prospect of changing fiscal rules would have caused spasms in UK debt markets. However, today the backdrop is different. The markets have reacted well to the new Labour government. They may also be more willing to give the Chancellor fiscal breathing room if she can use her Budget to deliver a roadmap to boost the UK’s long-term growth and productivity rates. 

To conclude, there is still a lot of speculation around the Budget. We will be following developments closely, along with giving you the latest analysis from Budget Day on 30th October.