Healey faces £24bn spending squeeze as inflation puts tax rises in play
Chancellor John Healey is facing a £24bn real terms squeeze on the public purse due to higher inflation and will be forced to hike takes to fund the government’s spending plans, a top think tank has warned.
Price growth will peak at 3.8 per cent early next year before a slow return to the Bank of England’s target of two per cent in 2029, which could hit government spending plans by nearly four per cent by the end of the decade, according to the National Institute of Economic and Social Research (Niesr).
In real terms, it will mean a squeeze on spending of £24bn, Niesr said.
Healey must avoid borrowing and instead raise taxes and reallocate spending to fund pledges including support for households on the cost of living and a boost to defence spending to three per cent of GDP by 2030, Niesr researchers warned.
The economics think tank’s deputy director professor Stephen Millard said the government would have to consider sweeping tax reforms on property and reliefs, cutting the welfare bill or breaking a manifesto commitment not to raise income tax.
“There is clearly no scope for really increasing borrowing, so it is about choices,” Millard told reporters. “It’s about do you want to pay for a whole bunch of new things out of higher taxes, or can you make spending cuts elsewhere.”
The latest forecast emphasised higher inflation would erode raw spending plans by the government. The fiscal headroom has not, however, suffered a deterioration beyond around £3bn over the last three months, estimates indicate.
The Westminster-based organisation takes a more pessimistic view of the UK economy’s trend growth rate than the Office for Budget Responsibility, meaning that it believes there is now a buffer of £3.4bn compared to just over £7bn in the spring.
The OBR’s more optimistic forecast from before the Iran war found that the size of the headroom was £22.7bn.
Niesr director David Aikman warned Healey that “treading water is not enough” as he urged the new Chancellor to rapidly decrease the size of public debt given UK borrowing costs were the highest out of any G7 nation.
While growth was revised up slightly in its forecast to 1.1 per cent both this year and in 2027, it would remain below the expected trend rate of around 1.2 per cent.
“Every major shock this century has ratcheted the debt ratio higher, and none of that increase has been reversed,” Aikman said.
“If we are to rebuild the capacity to absorb the next shock, we will need a determined plan to bring debt down over time.
“It is not hard to imagine where that next shock may come from: from the still-unsettled situation in the Middle East, or from a sharp correction in US equity markets, where valuations rest heavily not just on AI delivering, but on today’s leading firms capturing a large slice of the eventual returns.”
Tax fears mount
Niesr’s upgrade to its inflation forecast raised questions about whether the Bank of England could hike interest rates.
Millard argued there was a “case” for interest rates to be hiked although he doubted the Bank would tighten monetary policy as policymakers would instead take a more cautious approach.
He said higher interest rates would be “insurance against the possibility of further price rises coming” and ensure that wage growth pressures remain subdued.
The organisation’s hawkish forecast on inflation sends the Bank’s Monetary Policy Committee a stark warning about price stability in the UK, with rate-setters only hitting the target in just about three of the last 10 years.
Inflation averaged at about 3.4 per cent in 2025 and 2.5 per cent in the last two years as the UK economy came to grips with the energy price shock from the war in Ukraine and higher business taxes.
The Bank of England’s Monetary Policy Committee is set to reach a verdict on whether to hold or raise interest rates on Thursday, with a new set of forecasts for inflation and growth also set to be published.
City analysts expect interest rates to be held although many will be looking out for updates on price growth and signals on potential hikes in upcoming meetings.