What are the Chancellor’s options in the Autumn Budget?

Rob Morgan, Chief Investment Analyst at Charles Stanley, warns that high government bond yields, stubborn inflation and sluggish growth are creating a tough backdrop for November’s Budget. With a £30bn shortfall in the public finances, the Chancellor may have little choice but to turn to tax rises.

High government bond yields, persistent inflation, and sluggish economic growth present a challenging backdrop for November’s fiscal event.

With the Budget still weeks away, speculation is mounting over what the Chancellor might announce on 26th November. A projected £30 billion shortfall in the public finances will likely necessitate tax increases – not only to comply with fiscal rules, but also to reassure bond markets and keep government borrowing costs in check.

A difficult landscape

There’s no easy way out. In September, the yield on 30-year UK government bonds, or ‘gilts’, surged to its highest level since 1998 – north of 5.5%. While this is partly driven by global trends, UK yields remain notably higher than those in Europe and the US.

Several factors are contributing to this. Firstly, international investors are becoming increasingly concerned about the government’s ability to control spending. They fear tax rises to compensate will ultimately stunt growth and weaken public finances further. 

Secondly, the unwinding of ‘quantitative easing’ that took place during the Covid-19 pandemic has meant a steady stream of gilts entering the market from the UK’s central bank –  Bank of England (BoE). These gilt sales have come at a time when institutional demand for longer dated UK government debt from traditional buyers, such as pension funds is drying up. This imbalance has pushed prices down and yields up.

Finally, the UK still has an inflation problem with the consumer price index (CPI) expected to be double the BoE’s target in September. This raises the cost of index-linked debt (around 25% of public debt) and feeds into inflation-linked public spending. Rising employment costs are also contributing to persistent service-sector inflation. While inflation concerns persist in the US, the rate-cutting cycle over the pond appears more assured, and inflation is far lower in Europe and Japan.

The good news is that the rise in gilt yields has been relatively orderly, with buyers stepping in at lower prices. Moreover, the increase affects only new borrowing, not existing debt – giving the government some time to adjust course. Still, it’s a warning sign. If yields remain elevated without a corresponding rise in growth or productivity, the situation could worsen.

The Budget context

This is the environment in which Rachel Reeves will deliver her second Budget, guided by updated forecasts from the Office for Budget Responsibility (OBR).

The OBR’s projections will hinge on assumptions about growth, interest rates, and productivity over the next five years. Any revision of these could mean the loss of headroom against the fiscal rules. Something the Chancellor has previously said are “non-negotiable”. These are:

• No borrowing to fund day-to-day public spending by the end of the current parliament.
• Government debt must fall as a share of national income by the same deadline.

In March’s forecast, the OBR estimated Reeves had just £10 billion of headroom — a slim margin. Since then, the government has reversed planned benefit cuts and faced rising borrowing costs, making the situation considerably worse.

The size of the shortfall is now thought to be £30 billion. This could mean substantial tax increases may be unavoidable in the absence of significant spending cuts that seem politically impossible.

Despite declaring after last year’s Budget that she “would not be coming back” with further tax hikes, Reeves may now have little choice. Still, she’ll be keen to limit the tax burden to support growth as far as possible.

What are the options?

It’s unlikely that smaller revenue sources like capital gains tax (CGT) or inheritance tax (IHT) can make a meaningful dent in the shortfall. CGT may already be at a tipping point where higher rates discourage asset sales, which reduces overall tax receipts. 

Meanwhile, proposed IHT changes encouraging gifting – including pension withdrawals – have already accelerated wealth transfers to the younger generations. This can boost tax receipts, as gifted money is more likely to be spent and pension withdrawals beyond the tax-free lump sum are taxable. Tightening gifting rules, one of the rumours doing the rounds, could reverse this effect, potentially dampening economic activity and tax revenues – so the sensible thing to do would be to steer clear.

Only the major taxes can realistically generate the required revenue: income tax, VAT, National Insurance, and corporation tax. Corporation tax is likely off the table as the UK needs to attract investment. National Insurance was already increased for employers, and further hikes could hurt job creation, so that’s likely a no-go area too.

That leaves income tax and VAT. Raising either would break manifesto pledges, but the Chancellor may view this as the lesser evil compared to a patchwork of smaller measures that risk undermining growth and investor confidence.