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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is the Rene M Kern professor of practice at Wharton School, chief economic adviser at Allianz and chair of Gramercy Fund Management
There was a palpable sense of relief in markets over the UK Budget with investors appearing to welcome its fiscal prudence.
The incoming Labour government had bet in last year’s Budget on taking the pain early to secure later gains, swallowing the bitter pill of massive revenue-raising in hope of clearing the decks for a future of higher productivity and growth. It was a brave strategy that has failed to survive contact with reality.
As chancellor Rachel Reeves stood at the despatch box on Wednesday to deliver her second Budget, it was clear that “events” — both exogenous shocks and unforced errors — had conspired to force another dose of heavy fiscal lifting.
For a few hours at least, the magnitude of the tax effort and the larger than expected buffer against bad luck offered reassurance to investors. Yields on UK government bonds fell, both overall and relative to Germany and the US, sterling firmed and equities notched modest gains.
But if the short-term market verdict was favourable, the long-term verdict is far from sealed. If this Budget fails to ignite the growth and productivity engines, the UK risks extending a loop where each subsequent fiscal event becomes harder than the last, risking higher borrowing costs for both the public and private sectors, as well as inflation-causing currency depreciations.
To understand the chancellor’s bind, one must look at the shocks of the past 12 months. The government’s first Budget was defined by a grim inheritance and a manifesto that straitjacketed the Treasury by ruling out rate rises on income tax, value added tax and employee national insurance. Constrained, Reeves piled the burden on employers. The hope was that this would be the high-water mark of taxation.
That hope has been dashed. A rise in global protectionism is a headwind no open economy such as the UK can ignore. Worse, the government scored a series of own goals. Policy U-turns and confused policy messaging fuelled an “uncertainty risk premium”, pushing market interest rates higher than they otherwise would have been. The economic backdrop became consequently grimmer than hoped for, a development underscored by the Office for Budget Responsibility, which downgraded its projection for average growth over 2026-29 by 0.3 percentage points to 1.5 per cent, citing productivity weakness.
Having rejected a general rise in income tax rates — which would have broken a manifesto pledge but solved many fiscal headaches — Reeves opted for a cocktail of measures, some backloaded. These include freezing tax thresholds and a series of smaller levies and the closure of loopholes.
The chancellor also announced adherence to the IMF’s recommendation to limit fiscal headroom assessments to once a year and, crucially for markets, increased that headroom — the buffer against unanticipated shocks — to a more robust £21.7bn by 2029-30 and close to the average under the last six chancellors. It was this commitment to prudence that stayed the hand of the bond vigilantes.
There is much to commend in Wednesday’s Budget package. Despite the fiscal constraints, the government has protected public investment and public services. The elimination of the two-child benefit cap is a laudable move to aid the vulnerable. However, the cocktail approach to revenue raising is fraught with risk.
By hunting for cash in the nooks and crannies of the economy rather than using broad-based tools, the chancellor risks creating a distorted, leaky tax base.
Such measures are vulnerable to implementation slippage, invite aggressive avoidance strategies and add friction to an economy that desperately needs lubrication. The government risks having traded a political problem now, breaking a manifesto promise, for economic complications later.
This year’s Budget was never going to be easy. To her credit, Reeves has made a credible attempt to make lemonade out of lemons, a feat acknowledged by the markets’ reactions. Yet the strategy hinges on a gamble: that this specific “mosaic” of taxes will not choke off the very animal spirits the government needs to cultivate.
Despite the fiscal prudence of the Budget, if businesses and households retrench as a result of the measures, the fiscal hole will reopen. The chancellor has bought herself time with the markets; now she must bring sustained implementation, higher productivity and inclusive growth.