Spending pressures, not fiscal ‘headroom’, are the Chancellor’s key Budget challenge

War in the Middle East means that inflation in coming years will be higher than was expected in the spring. That has contributed to rising bond yields, which in turn increase government borrowing. Higher inflation will also drive up tax revenues, likely making the overall fall in ‘headroom’ against the fiscal rules smaller than widely expected. 

But inflation will erode the value of departments’ cash budgets, creating a major challenge for the Chancellor. John Healey will need to tolerate big real-terms cuts to some public services or top up spending plans, potentially by tens of billions of pounds. He should not wait until next year’s Spending Review to set out an overall spending ‘envelope’ that he would be willing to live within. Any plan to meet the fiscal rules will only be credible if based on credible spending totals. 

These are among the findings of the IFS Green Budget 2026, funded by the Nuffield Foundation and produced in association with Barclays, whose economic forecasts underlie this analysis. 

Higher inflation has effects that push up and down on government borrowing

• Higher interest rates on government debt will increase borrowing by roughly £10 billion in 2029–30. But higher inflation – while bad economic news – will boost tax revenues, and likely by more than it automatically increases spending on benefits. This effect reduces borrowing in 2029–30.
• The OBR ‘pre-measures’ forecast will likely show higher borrowing across the next five years than was expected in March, but with borrowing still falling over coming years and the fiscal rules still being met.
• In a plausible scenario, ‘headroom’ against the binding fiscal rule would be around £20 billion in 2029–30, compared with £24 billion forecast in March. But the degree of uncertainty is very high. The precise figure will be very sensitive to how the OBR expects higher inflation to affect earnings, as well as its judgements over employment, migration and health-related benefits. Changes to the earnings forecast alone could leave headroom around £10 billion higher or lower.
• Whatever the estimate, ‘headroom’ never gives a full picture of the health of the public finances. What matters is whether the Chancellor has a credible plan to reduce borrowing in coming years and thereby meets the spirit as well as the letter of the fiscal rules. 

Higher inflation will erode the spending power of departments’ budgets, exacerbating a large set of other pressures

• Under current plans, public service spending growth will slow in coming years. Even in the spring, next year’s Spending Review looked tough: if health spending grew at 2.7% per year in real terms and defence plans remained unchanged, this already implied real-terms cuts to other departments. Inflation forecasts are higher than in the spring, which will reduce the generosity of budgets even more. In the face of these pressures, and given current paths for health and defence, avoiding cuts to departments’ budgets could need a combined top-up to day-to-day and investment spending of around £25 billion in 2030–31.
• There are a host of other spending pressures and ambitions. Chief among these is defence: increasing defence spending to 3% of GDP by 2030 would cost £11 billion in 2030–31, across day-to-day and investment spending. 
• A choice to leave spending totals unchanged would implicitly be a choice to cut some budgets and allow the quality and/or quantity of some public services to fall. On the other hand, increasing spending to avoid cuts to budgets and fund higher defence spending could require tax rises or benefit cuts of around £35 billion. The Chancellor must decide where to land on that spectrum. 
• The Chancellor’s plan to reduce borrowing in order to meet the fiscal rules will be predicated on the spending totals he sets out. If John Healey sets out spending envelopes for public services that he would not be willing to live within, his plan for meeting the fiscal rules will not be credible.

Now is not a good time to substantially increase borrowing

• Debt remains historically high. Balancing the current budget by 2029–30 would see debt stabilise but not meaningfully fall. The debt interest bill has more than doubled as a share of GDP since 2019 and now makes up £1 of every £13 the government spends. Any significant top-up to day-to-day spending should be met through tax rises or spending cuts elsewhere, rather than increased borrowing.
• The Chancellor could borrow more to increase public investment in financial assets without being constrained by the fiscal rules. If well targeted, investment could deliver economic returns and promote other government priorities. But any extra borrowing would still raise debt and thereby increase the cost of debt servicing. Decisions of what to invest in – and how – should not be based solely on how they would be treated by a particular fiscal rule.

Helen Miller, Director of IFS, said: 

‘John Healey likely faces a forecast in which borrowing is still expected to fall in coming years and the fiscal rules are still being met. Despite that, a “steady-as-she-goes” Budget is not an option available to the Chancellor. Choosing to stay the course with the inherited tax and spending plans would mean allowing inflation to blow departments’ spending plans off course. It would be a choice to tolerate chunky cuts to the quantity or quality of some public services – cuts that would be larger if defence spending was increased within existing totals. 

‘The Chancellor does not have to make detailed spending plans at this Budget. And he could scale back his ambitions for defence or other public services, or make them contingent on the economy looking stronger by the time of next year’s Spending Review.

‘But for plans to reduce borrowing and meet the fiscal rules to be credible, the Chancellor must set out overall spending envelopes that he would be genuinely prepared to live within. If he chooses the path of squeezing public spending, he should be transparent that there are tough years ahead for some public services. Simply pencilling in implicit cuts that he has no intention of delivering would make the Budget a work of fiction.’

Jack Meaning, Chief UK Economist at Barclays, said:

‘This Budget comes at a moment when the wary eyes of global financial markets are elsewhere. One of the Chancellor’s key priorities should be to keep them there.

‘The UK is not out of the woods, and the Chancellor must be alive to the challenges coming down the track. Inflation is on the rise and will weigh on demand over the coming quarters, as will the associated tightening of financial conditions. These pressures come on top of the fiscal consolidation implied by the current tight spending plans.

‘But parts of the economic backdrop may give the Chancellor some comfort. Growth has been more resilient than many expected this year, supported by consumer spending and business investment, particularly in technology. Buoyant investment is exactly what the UK needs to spur sustainable, long-term growth, especially if it delivers productivity gains across the wider economy, as our research shows.

‘There is a path to a more positive economic story. Eight in ten firms say they would increase investment if the Chancellor could provide them with greater certainty from the dispatch box,^* while investors are searching for calm amid a storm of volatile global debt markets. Chancellor Healey should strive to deliver on both.’ 

^{*According to the Barclays Business Prosperity Index.}

Mark Franks, Director of Welfare at the Nuffield Foundation, said: 

‘Higher inflation has real consequences for public services and the people who rely on them: when departmental budgets are fixed in cash terms, rising prices reduce what those budgets can buy, potentially affecting the quality and availability of services. It also matters for taxpayers: with income tax thresholds frozen, inflation-driven increases in nominal earnings are likely to pull more people into higher tax bands. Decisions on tax and spending made at this Budget and other fiscal events should reflect a coherent strategy for the public finances and public services, rather than being shaped by the vagaries of inflation.’