UK government borrowing costs have risen sharply in reaction to the news that the Chancellor has decided against increasing income tax rates in the upcoming budget.
The interest rate on 10-year government bonds, known as the yield, rose to 4.56% in early trade from 4.44%, indicating how much it would cost the government if it chose to borrow during the period.
The rise in yields reflected concerns in financial markets about how the government will meet its spending and borrowing commitments without income tax increases.
Yields later declined after news that the government’s fiscal deficit was likely to be lower than experts had predicted, but recovered to 4.57% by Friday evening.
The Chancellor has not brought forward a widely reported proposal to increase income tax rates by 2p while cutting National Insurance by the same amount, after receiving a better-than-expected forecast from the Office for Budget Responsibility (OBR), the BBC understands.
The manifesto-breaching measure could have raised several billion pounds, and was sent to the OBR earlier this month as a costing option to help close a £30 billion gap in the public finances caused largely by falling productivity.
But the OBR’s latest assessment seems to suggest that the projected strength of wage and tax receipts over the coming years has offset several billion pounds of that gap, bringing it closer to £20 billion.
Gilt markets reacted strongly on Friday morning to a Financial Times report that the Chancellor was abandoning the tax plan, but markets softened slightly after news of an improved OBR forecast. By mid-afternoon, gilt yields were hovering around 4.53%, but the day began trading higher than before.
UK gilts have fallen sharply in recent weeks as expectations for lower interest rates grew.
Ruth Curtis, chief executive of the Resolution Foundation – the think tank that first proposed the idea of increasing income tax by 2p and cutting National Insurance by the same amount – said the latest budget rumors threatened to trigger market activity.
“It is normal for economic forecasts and policies to change ahead of the Budget. It is not normal for so much of this to be made public,” he said.
“The market volatility this morning and in recent weeks suggests that the approach to market-sensitive forecast information should be seriously considered.”
Russ Mould, investment director at AJ Bell, said Rachel Reeves had put financial markets and buyers of UK debt on edge by repeatedly stressing the need to plug the “fiscal black hole”. But, he said, by rejecting an income tax increase, bond market investors may question his ability to do so.
Andrew Goodwin, chief UK economist at Oxford Economics, said the episode suggests market confidence in the government’s approach to budget finances will be tested.
“If the market doesn’t find the OBR’s forecast credible then it’s clearly not a good idea to raise small taxes to deal with a small problem,” he said.
He said the OBR’s forecasts had been “too optimistic about continued growth, and if those forecasts were not corrected it would be “risky” for the Chancellor to impose all budget plans on them.
“There is a good chance that the market will conclude that the problems have not been resolved and the government will be back to square one in the next financial year.”
A Treasury spokesperson said: “We do not comment on speculation about tax changes outside of fiscal events. The Chancellor will present a Budget that adopts appropriate choices to build a strong foundation to secure Britain’s future.”
Reeves has previously confirmed that both tax increases and spending cuts are on the table for the budget. The Chancellor needs to find more money to meet his self-imposed “non-negotiable” rules for government finances.
There are two main rules:
- No borrowing for everyday public spending until the end of this Parliament
- To reduce government debt as a share of national income by the end of this Parliament
Speaking ahead of the report of improved OBR forecasts, Zeena Benn, managing partner at Sullivan Street Partners, said investors had braced themselves for an income tax rise in the Budget, so the report that the Chancellor was not going ahead with it was “a bit of a surprise”.
The other issue for investors was how the government would meet its budget shortfall, Ms Ben said.
“Are you going to close that hole and step back from fiscal responsibility?” he told the BBC’s Today programme.
“This then reduces confidence, which then translates into higher bond yields, which then translates into higher borrowing costs, creating an even bigger hole.”
