Starmer and Reeves drop proposal to increase income tax rates in Budget

Starmer and Reeves drop proposal to increase income tax rates in Budget

The new UK Labour government, led by Prime Minister Keir Starmer and Chancellor Rachel Reeves, has reversed its previously signaled intention to increase income tax rates in its first Budget. The decision, aimed at addressing a significant fiscal deficit, triggered an immediate and sharp sell-off in the UK government bond market, causing borrowing costs to rise.

Context & What Changed

Following its recent election victory, the UK's new Labour government inherited a precarious fiscal position, characterized by a debt-to-GDP ratio approaching 100% (source: ons.gov.uk) and persistent structural deficits exacerbated by slow economic growth. During the election campaign and in its initial days, the administration, led by Prime Minister Keir Starmer and Chancellor Rachel Reeves, had signaled that tax increases, including on personal income, would be necessary to fund public services and restore fiscal sustainability. This was widely interpreted by markets as a commitment to fiscal orthodoxy.

The pivotal change occurred when the Chancellor's office briefed that the upcoming Budget would not include increases to headline rates of income tax, National Insurance, or VAT (source: ft.com). This abrupt policy reversal represents the new government's first major economic test. The decision immediately unsettled financial markets, which interpreted the move as a potential shift away from fiscal consolidation. The primary market reaction was a significant sell-off in UK government bonds (gilts), causing their yields to rise sharply. This increases the cost of government borrowing, further complicating the fiscal arithmetic.

This event is highly consequential due to its strong parallels with the September 2022 "mini-budget" under the Truss administration. That event, which proposed large, unfunded tax cuts, triggered a severe crisis of confidence, a collapse in the value of the pound, a spike in gilt yields, and required emergency intervention by the Bank of England to stabilize pension funds (source: bankofengland.co.uk). The market's swift and negative reaction to the current news demonstrates its heightened sensitivity to any perceived deviation from fiscal discipline by a UK government, regardless of its political orientation. The government is now in the difficult position of having to find alternative, and potentially more politically painful, ways to fill a fiscal gap estimated to be in the tens of billions of pounds annually (source: ifs.org.uk).

Stakeholders

1. UK Government (H.M. Treasury & No. 10): Chancellor Rachel Reeves and Prime Minister Keir Starmer are the primary actors. Their core challenge is to establish economic credibility while navigating the political constraints of their electoral mandate. This U-turn puts their reputation for fiscal responsibility at immediate risk and forces them to reconsider their entire budgetary strategy.

2. Financial Markets (Gilt Investors): This group includes domestic and international pension funds, insurance companies, asset managers, and sovereign wealth funds. Their confidence is paramount. Their collective action of selling gilts directly determines the government's borrowing costs. Their reaction signals a demand for a clear and credible plan for fiscal consolidation.

3. Bank of England (BoE): As the UK's central bank, the BoE is responsible for both monetary policy and financial stability. A sustained rise in gilt yields could complicate its efforts to manage inflation. In a crisis scenario, as in 2022, the BoE might be forced to intervene to prevent disorderly market conditions, a move that would compromise its operational independence and policy objectives.

4. Office for Budget Responsibility (OBR): The UK's independent fiscal watchdog. The OBR's forthcoming independent forecasts of the economy and public finances, which will accompany the Budget, are now even more critical. Its assessment of the government's new plans will be a key determinant of market confidence.

5. UK Public and Businesses: The ultimate stakeholders. They will be affected by the eventual policy choices—be it through cuts to public services, alternative 'stealth' tax rises (like freezing thresholds), or the broader economic impact of higher interest rates and reduced investor confidence.

6. Credit Rating Agencies (Moody's, S&P, Fitch): These agencies will be closely monitoring the situation. A failure to present a credible fiscal plan could lead to a downgrade of the UK's sovereign credit rating, which would further increase long-term borrowing costs for both the government and the private sector.

Evidence & Data

The market's reaction provides the most direct evidence of the policy shift's impact. On the day of the announcement, the yield on the UK 10-year gilt, a key benchmark for government borrowing costs, jumped by approximately 18 basis points, rising from 4.15% to 4.33% in a single trading session (author's compilation from market data). While less dramatic than the 50+ basis point daily swings seen during the 2022 crisis, this is a significant and costly move for a G7 economy, indicating deep investor concern.

The fiscal context is defined by challenging metrics. The UK's public sector net debt stands at 99.8% of GDP as of Q1 2025, its highest level since the early 1960s (source: ons.gov.uk). The fiscal gap—the amount of consolidation needed to stabilize debt as a share of the economy—is estimated by organizations like the Institute for Fiscal Studies (IFS) to be between £20 billion and £30 billion per year by the end of the forecast period (source: ifs.org.uk). Forgoing an income tax rise removes one of the most straightforward (though politically difficult) levers to close this gap.

Debt servicing costs are already a major line item in the budget. In the last fiscal year, debt interest payments amounted to over £100 billion, more than the entire education budget (source: obr.uk). A sustained 0.2 percentage point (20 basis point) increase in the effective interest rate on the UK's £2.7 trillion national debt would, over time as debt is refinanced, add more than £5 billion to the annual interest bill, equivalent to the budget for thousands of new police officers or nurses.

The 2022 precedent is critical data. During that crisis, the 30-year gilt yield rose by over 120 basis points in a matter of days, forcing the BoE to launch a temporary £65 billion bond-buying program to prevent a fire sale of assets by liability-driven investment (LDI) funds used by pension schemes (source: bankofengland.co.uk). This recent history has conditioned the market to react forcefully to perceived fiscal risks.

Scenarios (3) with probabilities

Scenario 1: Pivot to Spending Cuts (High Probability: 60%)

Having publicly ruled out major tax rises, the government’s most direct path to fiscal credibility is to announce a significant program of public spending cuts in the upcoming Budget. This would involve revising departmental spending plans downwards for the years ahead, likely impacting unprotected areas like local government, justice, and transport. This strategy would aim to placate markets by demonstrating fiscal resolve. However, it would be politically toxic, breaking implicit promises to improve public services and inviting accusations of austerity, which the Labour party campaigned against. The impact would be a gradual stabilization of gilt yields, but at the cost of severe political capital and potential damage to long-term economic growth if capital investment is cut.

Scenario 2: The 'Growth Gamble' (Low Probability: 15%)

The government could attempt to emulate the Truss strategy’s stated goal (but not its methods) by arguing that supply-side reforms (e.g., liberalizing planning laws, boosting private investment) will generate sufficient economic growth to close the fiscal gap without major tax rises or spending cuts. The Budget would contain ambitious growth forecasts, but the OBR would likely certify them as highly uncertain. This is a high-risk path. Markets would likely view it as unrealistic and fiscally irresponsible, risking a repeat of the 2022 crisis. This could lead to a further spike in gilt yields, a credit rating downgrade, and an eventual forced, and more painful, fiscal U-turn.

Scenario 3: A Mix of 'Stealth Taxes' and Delayed Consolidation (Medium Probability: 25%)

This scenario involves the government seeking to fill the fiscal gap through less transparent or politically salient measures. This could include extending the freeze on income tax thresholds (fiscal drag, which pulls more people into higher tax bands due to inflation), closing specific tax loopholes, and imposing or extending windfall taxes on sectors like banking or energy. The consolidation plan might also be heavily back-loaded, with the most difficult decisions pushed to later in the parliamentary term. While this might avoid immediate market panic, it could be perceived as a lack of a serious long-term strategy, leading to persistently elevated borrowing costs and continued economic uncertainty that dampens business investment.

Timelines

Immediate (1-4 Weeks): A period of intense communication from H.M. Treasury to reassure investors. Gilt markets will remain volatile, reacting to every statement and rumour ahead of the Budget.

Short-Term (1-3 Months): The Budget statement is the critical event. The Chancellor will present the full fiscal plan, accompanied by the OBR's independent forecast. The market reaction in the hours and days following the statement will determine the UK's near-term economic trajectory.

Medium-Term (3-12 Months): The government will begin implementing its budget. Economic data (GDP, inflation, borrowing figures from the ONS) will provide the first real-world test of the chosen strategy. Credit rating agencies will likely issue their updated assessments of UK sovereign debt during this period.

Long-Term (1-5 Years): The cumulative effects of the fiscal strategy on public services, economic growth, and the national debt will become apparent. The success or failure of this initial economic policy will heavily influence the government's political standing and its prospects at the next general election.

Quantified Ranges (if supported)

Fiscal Gap: The structural deficit requiring closure is credibly estimated in the range of £20 billion to £30 billion per annum by 2029-30 to ensure debt is falling as a percentage of GDP (source: ifs.org.uk).

Borrowing Cost Impact: The immediate market reaction added 15-20 basis points to the 10-year gilt yield. A failure to deliver a credible budget could see yields rise by 50-100 basis points or more, mirroring the 2022 crisis.

Annual Debt Service Cost Increase: A persistent 100 basis point (1%) increase in the effective rate on UK government debt would eventually increase the annual interest bill by approximately £27 billion (author's calculation based on £2.7T debt stock), effectively wiping out any savings from forgoing tax rises.

Risks & Mitigations

Risk 1: Loss of Market Confidence: The primary risk is a full-blown market crisis, leading to spiraling borrowing costs, financial instability, and a forced, chaotic austerity program.

Mitigation: Deliver a Budget that is fully costed, transparent, and receives a positive endorsement from the OBR. The Chancellor must prioritize clear, consistent, and credible communication with markets.

Risk 2: Political Instability: A pivot to deep spending cuts would betray the government's electoral platform, potentially causing a rebellion from its own MPs and a collapse in public support.

Mitigation: Frame any spending restraint as a drive for 'efficiency' rather than 'austerity'. Target cuts carefully and accompany them with a strong narrative about the difficult economic inheritance. Seek to build a cross-party consensus on difficult choices where possible.

Risk 3: Economic Stagnation: Fiscal consolidation, whether through spending cuts or stealth taxes, will act as a drag on an already fragile economy. If implemented too aggressively, it could trigger a recession, which would be self-defeating by reducing tax revenues and increasing welfare spending.

Mitigation: The fiscal plan must be paired with a credible and detailed pro-growth strategy, focusing on supply-side reforms that can be implemented quickly. The government must coordinate its fiscal stance with the Bank of England's monetary policy to avoid overtightening.

Sector/Region Impacts

Infrastructure & Public Investment: Publicly funded capital projects are highly vulnerable under a spending-cut scenario. Major transport, energy, and digital infrastructure programs could be delayed, re-scoped, or cancelled, impacting the construction, engineering, and materials sectors.

Public Services: Unprotected government departments (e.g., Justice, Local Government, Transport) face the highest risk of deep budget cuts, which will impact service quality, public sector employment, and outsourcing contracts.

Financial Services: Pension funds and insurance companies, as major holders of gilts, face balance sheet volatility. The entire sector is exposed to the macroeconomic instability that would result from a loss of confidence in UK fiscal policy.

Regional Development: The 'Levelling Up' agenda, aimed at reducing regional economic disparities, is at risk. Cuts to regional investment funds would disproportionately harm areas in the North and Midlands of England, which rely more heavily on public investment.

Recommendations & Outlook

For Public Sector Leaders: (Scenario-based assumption) Department heads and agency leaders should prepare for a high likelihood of budget austerity as outlined in Scenario 1. This requires initiating immediate reviews of discretionary spending, re-prioritizing programs, and developing efficiency plans. Capital projects without ring-fenced funding are at particular risk.

For Infrastructure & Industry CFOs: (Scenario-based assumption) The outlook for UK public contracts has deteriorated. Firms heavily reliant on government spending must stress-test their business models against project delays and cancellations. Diversification of revenue streams and a focus on privately financed projects should be prioritized. All corporate financial planning should now assume a higher baseline for UK interest rates and borrowing costs for the medium term.

Outlook: This policy U-turn is a critical misstep for a new government seeking to establish its economic credentials. It has unnecessarily backed itself into a corner, forcing a difficult choice between breaking fiscal promises or breaking political ones. The memory of the 2022 mini-budget crisis is fresh, and the market's leash on the UK government is exceptionally short. (Scenario-based assumption) The most probable outcome is a budget that combines significant, politically painful spending cuts with some less-visible tax increases, as described in Scenarios 1 and 3. The government will attempt to frame this as 'pragmatic fiscal responsibility,' but it will be a severe test of its political discipline and public support. The immediate future of UK public finance, infrastructure delivery, and economic stability now hinges entirely on the credibility of a single fiscal event: the upcoming Budget.