Iran war threatens Healey's Budget plans, think tank warns

The recent price surge attributed to the US-Israel war in Iran poses a significant challenge for Chancellor John Healey as he prepares his first Budget, according to a prominent think tank.

The Institute for Fiscal Studies (IFS) has expressed concern that inflation rates higher than anticipated could undermine the government's planned expenditure on public services. As a result, Chancellor Healey may have to face tough decisions regarding spending cuts, tax increases, or a combination of both.

The IFS has encouraged the government to prioritize credible spending plans rather than suggesting unrealistic future cuts to balance the Budget.

While the Treasury has refrained from commenting on "rumour and speculation," Chancellor Healey highlighted the global impact of the Middle Eastern and European conflicts. He noted that these situations are contributing to increased costs for consumers, including higher fuel prices and more expensive mortgages within the UK.

"He said, 'Britain and our allies can face up to these challenges together.' He emphasized that his upcoming Budget will focus on maintaining fiscal discipline to enhance economic resilience and provide citizens with 'breathing space.'

Nonetheless, pressures are mounting on the government to reassure financial markets of its control over public finances, particularly as borrowing costs escalate.

The IFS cautioned Chancellor Healey to avoid making any spending promises in the Budget speech scheduled for 28 October unless he intends to keep them. "A 'steady-as-she-goes' Budget is not feasible for the chancellor," stated IFS director Helen Miller. She added that adhering to inherited tax and spending plans could allow inflation to derail departmental budgets and warned against implying cuts that he does not plan to implement, labeling such an approach as unrealistic.

The ongoing conflict involving the US-Israel war against Iran, coupled with Russia's invasion of Ukraine, has contributed to rising energy prices globally. These increased costs are being passed on to consumers, manifesting as higher prices in stores and at fuel stations.

Additionally, these wars are driving up the interest payments on UK government debt, intensifying the financial pressure on Chancellor Healey.

While higher inflation can enhance tax revenues, it simultaneously diminishes the purchasing power of departmental budgets, according to the IFS.

'Breathing space'

The IFS shares the assessment of other analysts, noting that the recent turmoil within bond markets, along with rising inflation, may add approximately £10 billion to the government's borrowing forecasts for the fiscal year 2029-30.

However, the think tank still anticipates that the government will adhere to its fiscal rules, which stipulate that borrowing should be limited to investment projects up until the financial year 2029-30, while also reducing debt as a percentage of GDP. This is particularly relevant as inflation increases tax revenues.

The IFS predicts that compliance with these rules will be achieved, albeit with a smaller financial cushion, known as "headroom," estimated around £20 billion—lower than the previously predicted £24 billion buffer provided by the Office for Budget Responsibility (OBR) at the time of the Spring Statement.

Recent signals indicate that financial markets would find this reduced headroom acceptable. Furthermore, the IFS expects any "breathing space" for households to be short-lived and modest in scope.

Nevertheless, the IFS warns that in an unpredictable financial environment, its forecasts carry a high degree of uncertainty. The official projections from the OBR, which the chancellor relies upon when formulating his strategy, may yield significantly different conclusions.

The IFS estimates that to sustain departmental budgets amidst heightened inflation, the government could require an additional £25 billion by 2029-30, not factoring in plans for increased defense spending. Such an escalation in funding requirements would likely necessitate substantial tax increases.

Chancellor Healey may opt not to address spending totals in this upcoming Budget, deferring such decisions for future occasions, such as the next Spring Statement or Spending Review, when the economic outlook may appear markedly different.

However, the IFS cautioned that the spending strategies inherited from the former Chancellor Rachel Reeves would ultimately result in several departmental budgets failing to keep pace with inflation over time. Neglecting to address this matter could undermine the credibility of the government's financial plans.

Historically, previous chancellors have often relied on similar strategies that involve outlining unrealistic future spending proposals to meet fiscal rules at the moment, only to amend those plans subsequently.