Scale of challenge facing Reeves comes as Starmer fails to rule out tax rises in the Budget
Rachel Reeves will need to raise taxes by the equivalent of 3p on income tax in order to fill the black hole in the nation’s finance, analysis shows.
The Chancellor is expected to need to raise around £32bn at November’s Budget in order to fill a gap in the country’s balance sheet, and restore the £10bn “headroom” against her fiscal rule that day-to-day spending must be met by income and not borrowing.
Speculation is mounting that the Chancellor is considering breaching the Labour manifesto pledge not to raise direct taxation at the Budget.
Sir Keir Starmer on Wednesday declined to say that the Government would stick to its manifesto pledge not to raise VAT, income tax or national insurance at PMQs.
The most likely scenario is that Reeves couples an income tax rise of 1p or 2p with other smaller tax rises to fill the hole in the finances. However, the 3p figure gives an insight on the scale of the financial difficulty facing the UK.
Size of Budget black hole
There are varying estimates as to the size of the financial hole Reeves is facing.
Capital Economics estimates the Chancellor will need to raise £31bn at the Budget, to bring her back to the situation in March when she had £9.9bn “headroom”.
This is close to an estimate by the Institute for Fiscal Studies earlier this month, that said she faced a £22bn deficit which, if she wanted to restore her headroom, would mean she would need to raise £32bn.
HMRC figures suggest that increasing the basic rate of income tax from 20 per cent to 23 per cent and the higher rate from 40 to 43 per cent would raise around £30bn a year by the end of this Parliament.
While the Chancellor is refusing to rule out an increase in income tax, a 3p rise would flagrantly breach Labour’s manifesto commitment.
A 1p increase in the basic rate of tax – paid by those earning between £12,570 and £50,270 per year – would raise around £8.2bn a year, and a rate three times this would raise £24.6bn, according to the HMRC.
For the higher rate of tax – paid by those earning between £50,270 and £125,140 – a 1p rise would raise around £2.1bn, with a 3p rise raising £6.3bn.
While raising the basic rate would also breach the manifesto pledge, it is thought a more likely option with some economists arguing it is the simplest way of raising the most money.
But these increases would mean someone on a roughly average wage of £35,000 taking home £672 less per year.
Amount needed could be even higher
Ruth Gregory, deputy chief economist at Capital Economics, said: “We suspect the Chancellor will need to find about £31bn of revenue if she wishes to restore her headroom against her fiscal mandate.”
But she said the amount needed could be even higher if Reeves were to announce measures “to soften the blow and reduce inflation”.
“If she scraps VAT on domestic fuel prices, freezes fuel duty or if she scraps the two-child benefit cap, then she could have to raise closer to £40bn, similar to the tax-raising package seen in October 2024.
“This has increased the likelihood that the Chancellor will be forced to break labour’s election manifesto pledge not to raise the three big taxes on households.”
Robert Salter, a partner at accountancy firm Blick Rothenberg, suggested that a 3p increase to basic income tax would raise around £22.5bn to £24bn and a 3p increase to the higher rate would raise around £4.5 to £6bn.
“If she wishes to raise income tax, a significant element of this income tax increase would realistically need to be via increasing the basic rate of tax.
“This is because the absolute receipts from a 1p in the pound rise in the 20 per cent tax rate produce significantly more revenue than any increase to the 40 per cent or 45 per cent tax rates,” he said.
3p rise would reduce income by around £670
He added a 3p increase for someone on an average wage would be very significant, as it would increase the amount of income they owed overall by around £670.
In spring, Reeves had a £9.9bn buffer against her fiscal rules – the guidelines that govern her tax and spending decisions.
But the reversal of planned welfare cuts and an increase in the cost of debt have wiped this headroom out, meaning without further tax rises or spending cuts, Reeves will not meet her own rules.
During Prime Minister’s Questions Tory leader Kemi Badenoch attacked the Prime Minister over the state of the economy as he failed to say whether the Government would stick to its manifesto promises not to raise income tax, national insurance or VAT in the Budget.
He said: “The Budget is on the November 26, and we will lay out our plans, but I can tell the House now that we will build a stronger economy, we will cut NHS waiting lists and deliver a better future for our country.”
Badenoch replied: “If you work, they tax you more. If you save, they tax you more. If you buy a home, they tax you more. None of these taxes were in the manifesto, which he had four years to prepare.
