The government faces another extensive hole in the public finances after a series of U-turns and a likely, albeit uncertain, downgrade to the Office for Budget Responsibility’s (OBR) productivity forecasts, which will only be partially offset by lower interest rates. Throw in a couple of giveaways and an increase in headroom and our base case is that the government will need to engage in fiscal consolidation of around £35bn at the Autumn Budget.

Just how big a hole is the Chancellor facing?

Despite restoring headroom back in March, we think the government is currently set to miss its primary fiscal rule – to pay for day-to-day spending through taxes by 2029-30 – by about £20bn. This means the government will need about £30bn of tax rises to restore the paltry £9.9bn headroom it previously left itself. There are a few reasons for the shortfall.

First, and most importantly, the OBR will probably downgrade its productivity growth outlook. This is widely expected, but the size of the reduction is crucial. The most recent reports suggest that the OBR is set to downgrade its medium-term productivity forecast by 0.3ppts. That would cost the Chancellor about £21bn of headroom in 2029-30.

Admittedly, this isn’t guaranteed. The official measure of productivity remains dire, but those estimates rely on the Labour Force Survey (LFS), which – while improving – remains unreliable. If we adjust the available figures with payroll data, then productivity is growing at close to 2% y/y. The OBR will, rightly, be reluctant to downgrade its forecast when the data is this questionable. It’s another reason we think it’s not certain the OBR will take a hammer to its forecast.

Second, the government rowed back on its proposed benefit cuts. We think this will knock around £5bn off the government’s headroom. More importantly, it suggests that to be credible, most of the adjustment to fiscal policy will have to come through tax rises because spending cuts look increasingly difficult to get through parliament.

Third, no Autumn Budget would be complete without a couple of giveaways. Axing the two-child tax credit would cost around £3.5bn. Cutting the 5% VAT on energy bills would cost another £2.5bn.

On the plus side, we had thought the recent fall in gilt yields had come too late to be incorporated into the OBR forecast, but recent media reports suggest the chancellor will benefit from lower gilt yields. Taking current levels as a benchmark, this could knock about £2bn off borrowing costs.

In total, to get back to the £10bn of headroom Rachel Reeves had in March, she will probably have to raise around £30bn in taxes.

However, it’s entirely possible that the deficit is significantly bigger than this. If the OBR interest rate window was in fact earlier in the month, as we previously thought, then the £2bn in interest savings could easily turn into a £3bn increase in costs. What’s more, tax receipts have generally underperformed OBR forecasts in the last few years, if the OBR makes an adjustment for that then we could see the total deficit closer to £40bn.

Will the Chancellor leave herself more headroom with higher tax rises?

Given the recent reports the Chancellor is contemplating leaving herself a greater margin of headroom going forward, then we have to factor in even larger tax rises.

The rationale is obvious here. Between 2010-22, chancellors typically left around £30bn of headroom. So, a margin of £10bn is thin, to say the least. It leaves the Chancellor open to speculation about changes to fiscal policy every time the economic wind gusts in the wrong direction. More headroom would allow businesses and households to feel a bit more certain about the fiscal outlook and prevent another round of confidence-sapping speculation about tax rises ahead of the next fiscal event.

What’s more, a bigger margin of headroom would make the government look more fiscally responsible. An improvement in credibility could go some way to lowering gilt yields, especially if the government has managed to avoid another budget-induced inflation spike. That, in turn, would add to the headroom at future fiscal events. Indeed, we have already seen some recent evidence of this virtuous cycle in the recent fall in gilt yields.

However, a decrease in gilt yields would depend on the credibility of the fiscal consolidation plans. That would mean tax rises will have to start next year rather than being backloaded, although spending cuts probably will be. It also means the Chancellor can’t shy away from contentious areas, such as raising fuel duty.

We expect the Chancellor to increase her headroom by £5-10bn to between £15-20bn, with £15bn the base case. Ultimately, the increase in headroom will be determined by just how big the existing fiscal hole is. Finding £10bn to increase headroom with – on top of plugging a £30bn deficit without breaching the manifesto commitments or causing another burst of inflation – is a big ask.

The upshot is that we’re probably looking at fiscal consolidation of around £35bn, with the majority coming from tax rises and some backloaded spending cuts, with the risk of a significantly larger fiscal consolidation.

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