UK borrowing costs spike on report government to scrap plans to raise income tax
UK borrowing costs spike on report government to scrap plans to raise income tax
The new UK Labour government has reportedly abandoned plans to increase income tax rates in its upcoming Budget, a reversal of recent signals from the Treasury. This abrupt policy shift has triggered a sharp sell-off in UK government bonds, causing borrowing costs to rise significantly, and a decline in the value of the pound sterling. The decision creates uncertainty over how the government will address a multi-billion pound fiscal gap and fund its public spending commitments.
Context & What Changed
The United Kingdom's newly elected Labour government, led by Prime Minister Keir Starmer and Chancellor Rachel Reeves, has inherited a formidable set of economic challenges. These include a national debt approaching 100% of GDP (source: ons.gov.uk), persistent inflationary pressures, stagnant economic growth, and immense strain on public services, particularly the National Health Service (NHS). Against this backdrop, the Office for Budget Responsibility (OBR), the UK's independent fiscal watchdog, has projected a significant medium-term fiscal gap, estimated by institutions like the Institute for Fiscal Studies (IFS) to be in the range of £30-£50 billion per annum (source: ifs.org.uk). This gap represents the difference between projected government spending and tax revenues under current policies, which must be closed to ensure public debt falls as a share of the economy.
During the election campaign, the Labour party manifesto contained a firm pledge not to raise the rates of the three major taxes: income tax, National Insurance, and Value Added Tax (VAT). However, in the weeks following the election, facing the stark reality of the public finances, senior figures within the Treasury began to signal that a reconsideration of the income tax pledge was necessary to establish fiscal credibility and fund essential services. This was framed as a difficult but responsible choice. The expectation grew, both in Westminster and in financial markets, that the upcoming Budget on November 26 would include an increase in one or more income tax rates.
On November 14, 2025, this expectation was abruptly overturned by widespread reports that Chancellor Reeves had decided against the income tax rate hike. This U-turn represents a significant policy shift just days before a major fiscal event. The immediate market reaction was severe and negative. The news triggered a sharp sell-off in UK government bonds (gilts), causing their yields—which represent the government's cost of borrowing—to spike. The yield on the benchmark 10-year gilt reportedly jumped by over 25 basis points in early trading (source: ft.com, cnbc.com). Simultaneously, the pound sterling fell against major international currencies. This market reaction drew immediate comparisons to the financial turmoil of September 2022, when the Truss administration's unfunded tax cuts led to a crisis of confidence, highlighting the acute sensitivity of investors to perceived fiscal indiscipline in the UK.
Stakeholders
UK Government (Prime Minister Starmer & Chancellor Reeves): The primary stakeholders, whose political and economic credibility is now under intense scrutiny. They must navigate the treacherous path between honouring a manifesto pledge, satisfying market demands for fiscal sustainability, and delivering on their promises to improve public services. Their ability to present a coherent and credible alternative plan in the Budget is paramount.
The Treasury & Office for Budget Responsibility (OBR): HM Treasury officials are tasked with finding alternative revenue-raising measures or spending cuts to fill the fiscal gap. The OBR's role is critical; its independent forecast, to be published alongside the Budget, will be the definitive judgment on whether the government's new plan is fiscally sustainable. A negative assessment from the OBR would likely trigger further market turmoil.
Bank of England (BoE): The central bank's mandate to control inflation is complicated by fiscal instability. A sustained rise in government borrowing costs can feed into higher interest rates across the economy. If the government's fiscal stance is perceived as inflationary or reckless, the BoE may be forced to maintain a tighter monetary policy, potentially stifling economic growth.
Investors (Domestic & International): As the ultimate arbiters of the UK's borrowing costs, gilt market investors are a crucial stakeholder. The sell-off signifies their immediate disapproval and a demand for a higher risk premium to hold UK debt. Their confidence, or lack thereof, will dictate the financial constraints under which the government operates.
UK Public & Taxpayers: The public faces renewed uncertainty. The decision to forgo an income tax rate rise means the fiscal burden must fall elsewhere. This could manifest as cuts to public services, delays in infrastructure projects, or increases in less transparent 'stealth taxes,' such as freezing tax thresholds, which pull more people into higher tax brackets through inflation (fiscal drag).
UK Businesses & Large-Cap Industry: The spike in sovereign borrowing costs directly influences corporate borrowing costs, making investment more expensive. Fiscal uncertainty and the prospect of either reduced government spending or alternative tax hikes (e.g., on corporate profits) create a difficult environment for business planning. Sectors reliant on government contracts, such as infrastructure, defence, and outsourcing, face significant risks to their revenue streams.
Opposition Parties: Political opponents will exploit this U-turn as evidence of incompetence and internal division, seeking to undermine the new government's authority and public trust.
Evidence & Data
The market's reaction provides the most immediate and quantifiable evidence of the policy shift's impact. The yield on the UK's 10-year government bond, a key benchmark for long-term borrowing costs, surged by approximately 0.25 percentage points to over 4.5% within hours of the news breaking (source: cnbc.com). This is a substantial single-day move for a major sovereign bond market. For context, a sustained increase of this magnitude adds billions to the nation's annual debt interest bill as existing debt is refinanced.
The pound sterling fell by over 1% against the US dollar, dropping below $1.22 (source: theguardian.com), reflecting international investors' concerns about the UK's economic governance. This currency depreciation makes imports more expensive, potentially adding to inflationary pressures.
The core problem is the fiscal gap, which the IFS and others have consistently placed in the £30-£50 billion range needed to stabilize the UK's debt-to-GDP ratio, currently at a multi-decade high of around 99.8% (source: ons.gov.uk). An income tax rate rise was seen as one of the few levers large enough to generate a substantial portion of this sum. For example, a 1p increase in the basic, higher, and additional rates of income tax would raise approximately £7-8 billion per year (source: hmrc.gov.uk).
The decision to forgo this option forces the Treasury to consider a menu of less effective or more economically distortionary alternatives. Options include freezing personal tax allowances and thresholds, which the OBR has previously estimated could raise over £10 billion annually by the end of a parliamentary term through fiscal drag (source: obr.uk). Other possibilities, such as reforming non-domicile tax status or equalizing capital gains and income tax rates, are estimated to raise smaller sums, typically in the low single-digit billions annually.
The historical precedent of the September 2022 'mini-budget' looms large. During that episode, unfunded fiscal commitments led to a 1.5 percentage point spike in 10-year gilt yields over a matter of days, forcing an emergency intervention from the Bank of England and the eventual collapse of the government. The current market reaction, while less severe so far, follows the same pattern, demonstrating that investor tolerance for fiscal ambiguity in the UK remains exceptionally low.
Scenarios (3) with probabilities
Scenario 1: The "Stealth Tax & Spending Squeeze" (Probability: 65%)
In this scenario, the government adheres to its pledge on tax rates but compensates through a package of less transparent fiscal consolidation measures. The Budget would feature an extension of freezes on income tax and other tax thresholds, leveraging fiscal drag to increase revenue. This would be combined with targeted tax increases, such as an expansion of the windfall tax on energy producers and banks, and a clampdown on tax avoidance. The majority of the fiscal gap, however, would be filled by significant real-terms spending cuts for government departments not protected by existing spending commitments (i.e., outside of health and defence). Capital investment in infrastructure would likely be a primary target for delays and reductions. This approach is politically expedient as it avoids a headline-grabbing tax rise, but it risks being seen as fiscally insufficient by markets and economically damaging due to the spending cuts.
Scenario 2: "Market-Forced Reversal" (Probability: 20%)
Here, the initial negative market reaction fails to stabilize. Gilt yields continue to climb in the days leading up to the Budget as the government fails to convincingly articulate a credible alternative plan. The rising borrowing costs threaten to trigger a wider financial stability crisis, prompting public warnings from the Bank of England and credit rating agencies. Under this intense pressure, the Chancellor is forced into a second, more dramatic U-turn. The Budget on November 26 would either reintroduce the income tax rate rise that was just scrapped or announce an emergency package of extremely deep and immediate public spending cuts far beyond what was previously contemplated. This would severely damage the government’s credibility but would be seen as necessary to restore order to the markets.
Scenario 3: "The Growth Gambit" (Probability: 15%)
This high-risk, high-reward scenario sees the government pivot away from immediate fiscal consolidation. Instead of announcing major tax rises or spending cuts, the Budget focuses on a radical program of supply-side reforms aimed at boosting the UK’s long-term growth rate. This could include sweeping planning liberalisation, deregulation in key sectors like life sciences and technology, and investment tax incentives. The government would argue that the resulting economic growth would generate sufficient tax revenue to close the fiscal gap over the medium term. The OBR would likely be highly sceptical of the growth forecasts required to make such a plan add up, and markets would view it as an unfunded gamble, risking a severe negative reaction similar to that in Scenario 2. This is the least likely path given the current market sensitivity.
Timelines
Immediate (1-2 weeks): The period leading up to the Budget on November 26 will be critical. The government will be under immense pressure to leak details of its alternative plan to calm markets. Expect continued high volatility in gilts and sterling, with every ministerial statement intensely scrutinized.
Short-Term (Budget Day – end 2025): The delivery of the Budget and the accompanying OBR forecast will be the moment of truth. A credible plan, endorsed by the OBR, could stabilize markets. A plan deemed insufficient will lead to a protracted period of financial instability. Credit rating agencies (S&P, Moody's, Fitch) will issue their updated assessments of UK sovereign debt within weeks of the Budget.
Medium-Term (2026-2027): The real-world impact of the chosen fiscal path will become apparent. Economic data on growth, inflation, and public borrowing will reveal if the strategy is working. The government's ability to implement potentially unpopular spending cuts or tax changes will be tested. The Bank of England's interest rate decisions will be heavily influenced by the fiscal stance.
Long-Term (2028 onwards): The cumulative effects of the fiscal strategy will shape the UK's economic landscape, determining the level of public debt, the quality of public services, and the country's attractiveness for investment. The success or failure of this Budget will define the government's legacy and its prospects for re-election.
Quantified Ranges (if supported)
Fiscal Gap: The required fiscal consolidation is estimated at £30 billion to £50 billion per annum by the end of the forecast period to ensure the debt-to-GDP ratio is on a downward trajectory (source: ifs.org.uk, Resolution Foundation).
Borrowing Cost Impact: The initial 25-basis-point (0.25%) rise in 10-year gilt yields, if sustained, would increase the UK's annual debt servicing costs by approximately £2-3 billion for each year's new borrowing and refinancing needs, compounding over time (author's calculation based on UK Debt Management Office data).
Potential Revenue from Alternatives: Closing the full fiscal gap without raising major tax rates is challenging. Freezing tax thresholds could raise £10-15 billion annually by 2029 (source: obr.uk). Closing various tax loopholes (e.g., non-dom reform, private equity carried interest) might collectively raise £5-7 billion. This leaves a significant shortfall of £10-30 billion that would likely need to be met through spending cuts.
Risks & Mitigations
Risk 1: Sustained Loss of Market Confidence: The primary risk is a downward spiral where rising borrowing costs force austerity, which in turn weakens the economy, further spooking markets. This could lead to a sovereign debt crisis.
Mitigation: The Chancellor must use the Budget to present a clear, decisive, and fully-costed plan that is independently verified by the OBR. Pre-briefing key market participants and institutions on the broad strokes of the plan could help manage the announcement. Close and visible coordination with the Bank of England is essential.
Risk 2: Political Credibility Collapse: The perception of a government that is chaotic, indecisive, and driven by market whims rather than a coherent strategy could prove fatal. This erodes public trust and invites political instability.
Mitigation: Develop a strong and consistent narrative that frames the Budget decisions as a responsible long-term choice. The Prime Minister and Chancellor must present a united front and effectively communicate the rationale for their chosen path to the public.
Risk 3: Unintended Economic Damage: The alternative measures chosen may be more harmful to growth than a simple income tax rise. Deep spending cuts can create a fiscal drag, while complex tax changes can create uncertainty and deter investment.
Mitigation: The Budget should include a thorough impact assessment of the chosen fiscal measures. Any consolidation should be balanced with targeted, credible supply-side reforms to support business investment and productivity growth.
Sector/Region Impacts
Infrastructure & Construction: This sector is highly exposed. Government capital budgets are a common target for cuts during fiscal consolidation. Major transport, energy, and digital infrastructure projects could be delayed, re-scoped, or cancelled, with significant knock-on effects for the entire construction supply chain.
Public Sector & Outsourcing: Unprotected government departments (e.g., local government, justice, education) face the prospect of severe budget cuts, impacting service quality and employment. This will also directly affect large-cap firms that provide outsourced services to the public sector.
Financial Services: Increased volatility presents both risks and opportunities. However, the sector is a likely target for alternative revenue-raising, such as an expanded bank levy or windfall tax. Higher long-term interest rates will affect banks' balance sheets and lending margins.
Real Estate: Higher borrowing costs will dampen activity in both the residential and commercial property markets. A reduction in government infrastructure investment could also negatively impact property values in affected areas.
Regional Impact: A pivot towards spending cuts would disproportionately harm regions in the North of England, the Midlands, and Wales, which have a higher reliance on public sector employment and investment. The government's 'Levelling Up' agenda would be severely undermined.
Recommendations & Outlook
For Government Agencies & Public Bodies: (Scenario-based assumption): Assuming Scenario 1 ('Stealth Tax & Spending Squeeze') unfolds, agencies must prepare for a period of significant fiscal restraint. All non-essential capital projects should be paused pending review. Departments should model the impact of real-terms budget cuts of 5-15% over the next three years and identify core services for prioritization.
For Infrastructure & Large-Cap Firms: The risk profile for UK-centric projects has increased. Firms should immediately stress-test project viability against sustained higher borrowing costs and potential delays to government contracts. Diversifying revenue streams and funding sources geographically is now a strategic imperative. Boards should demand enhanced political risk monitoring.
For Investors: The UK now commands a higher political risk premium. Until a credible fiscal plan is presented and endorsed by the OBR, UK gilts and sterling will remain volatile. A defensive portfolio allocation is advised, favouring companies with strong balance sheets, international earnings, and low dependence on UK government spending.
Outlook: This U-turn marks a critical loss of innocence for the new government. It has traded a political problem (breaking a manifesto pledge) for a market credibility problem, which is far less forgiving. (Scenario-based assumption): The most probable outcome is a fiscally austere Budget that disappoints many of the government's supporters but is just enough to placate financial markets. The government's narrative will shift from 'change' to 'stability,' and its ambitions for public service reform and investment will be significantly curtailed. The memory of the 2022 crisis will act as a powerful disciplining force, ensuring that the final Budget, whatever its composition, will prioritize the cold arithmetic of the OBR over political aspirations.