The Chancellor has probably lost about half the fiscal headroom he inherited only a few months ago. Recent press reports suggest he will not seek to replenish it through further tax rises. That makes some sense and would make his life easier. However, it poses serious risks and could set us up for another round of tax increases in the future.

How do the UK fiscal rules work?

The Government has two main fiscal rules:

• Day-to-day spending must be covered by tax revenues — the Government should not borrow to fund routine spending by the end of the forecast period, which is now three years out, so 2029/30.
• Debt must be falling as a share of the economy — public sector net financial liabilities (PSNFL) must be lower in the final year of the OBR's five-year forecast than in the previous year.

In practice, the rules are designed to ensure that the Government can borrow to invest, while ultimately covering current spending with revenues and putting the debt burden on a downward path. One important caveat is that the fiscal rules are based on OBR forecasts of government tax receipts and spending three years ahead. Only the third year matters: borrowing can rise in years one and two, but the fiscal rule is satisfied as long as it is forecast to fall in year three. This leaves plenty of scope for “temporary” measures that last one or two years but expire before the third year of the fiscal rule, or for “buy now, pay later” policies that boost spending immediately but are funded by future tax increases. Expect these strategies to feature prominently in the Budget.

At the last Budget, the Government had £23.6bn of headroom against its primary fiscal rule. However, higher government bond yields and rising inflation have taken a significant chunk out of that. Add potentially slower growth and lower migration, and the headroom against the primary rule has probably fallen to around £12bn.

Is the £12 billion reduction a hit or a fiscal hole?

So, that is broadly where things stand. The question is: what does Healey do about it?

The most likely option, based on recent news reports at least, is to do nothing. That makes some sense, particularly from a political perspective. He can still argue that the headroom is larger than the £9.9bn buffer Rachel Reeves left in her first Budget. He will probably also argue that temporary geopolitical shocks, such as the war in the Middle East, are exactly what the buffer is there to absorb. Raising taxes whenever the buffer is eroded would defeat the point of having one.

It would also make his life much easier. Raising £12bn in taxes to rebuild the fiscal buffer would be almost impossible while also honouring the manifesto pledges not to raise the three big taxes—VAT, income tax and National Insurance—and taking action to reduce the cost of living.

It is therefore plausible that the Chancellor simply accepts the new, lower level of headroom. It is better viewed as a hit to the headroom than as a hole that must be filled.

But that is not without risks.

Why lower fiscal headroom leaves little room for error

Higher inflation and gilt yields may not be temporary

It is probably wrong to assume that the current rise in inflation and gilt yields is entirely temporary. The war in Iran has now lasted almost seven months, with little sign of a permanent resolution. Moreover, much of the rise in gilt yields is driven by structural forces, such as heavy debt issuance by governments and AI firms. These are likely to be lasting changes. The idea that inflation and gilt yields will quickly return to the levels the OBR expected in March therefore seems highly optimistic. If the cost of financing government debt has permanently increased, that should be reflected in higher taxes or offset by lower spending elsewhere.

The economic risks could increase further

The risks are weighted to the upside. Global oil stocks have been depleted by the war in Iran, while natural gas stocks in Europe are at their lowest level in decades. This clearly increases the risk of further price rises if there are more disruptions. Meanwhile, there is no sign that governments are reining in deficit spending in response to higher interest rates. The fiscal forecasts are therefore at least as likely to look worse this time next year as they are to look better.

A smaller buffer could damage confidence

Third, such limited headroom will invite the damaging speculation that undermined Rachel Reeves. Indeed, that is precisely why she more than doubled the headroom in the previous Budget. With so little room for error, every adverse move in gilt yields or inflation will prompt renewed speculation about which taxes may have to rise to fill the gap. That is distracting for the Government, undermines consumer and business confidence and, in turn, dampens growth.

Although simply accepting the hit to headroom may be good politics, it is bad economics. It would be better to accept some pain now in return for more stable public finances than to pin hopes on the economic outlook improving by the next Budget.

What does lower fiscal headroom mean for businesses?

The most obvious way Westminster decisions affect the real economy is through tax and spending choices. The amount of headroom the Chancellor seeks to maintain will directly shape those decisions. In turn, they will feed into businesses’ tax planning and the strength of consumer spending and demand.

Less obviously, the level of headroom will also affect business financing costs. Greater headroom would signal a more prudent fiscal policy and help bring gilt yields down, reducing financing costs for businesses.

Finally, a smaller degree of headroom makes future tax rises even more likely, further undermining confidence.

Could taxes still rise at the Autumn Budget?

Finally, accepting the hit to headroom does not mean there will be no tax rises in October. If the Government wants to act on everything from boosting defence spending and fixing social care to reducing the cost of living, taxes will have to rise accordingly. We will cover the Budget in more detail as it approaches.

Consumer confidence rose from -14 to -13 in September, its highest level since August 2024 and above expectations for a fall to -16, despite accelerating inflation and slowing wage growth.

This suggests that consumers were willing to keep spending in Q3 and to reduce their savings in the face of elevated inflation. It reinforces our view that the economy will grow by 0.4% in Q3, rather than the 0.2% we initially anticipated. That bodes especially well for retailers as we head into the all-important golden quarter.

What is more, for the first time in years, consumers are arguably more confident than the economic fundamentals suggest they should be. Inflation likely rose to 3.4% in September and wage growth probably slowed further, which would usually point to weaker confidence. This may suggest that animal spirits—the non-rational, emotional factors that influence economic behaviour and decision-making—are finally improving, as the chart below shows.

Of course, a tax-raising Budget is on the way, inflation will peak above 4% in the new year and unemployment will probably nudge back above 5%. All of this should weigh on sentiment in the coming months. For now, however, consumers appear confident enough to keep spending, which should support growth in Q3.

All told, consumers are becoming more confident despite turmoil in the Middle East pushing up energy prices. That should support consumer spending growth of around 1.2% this year—the strongest rate since 2022, when the economy was still recovering from the pandemic.

We expect the August Money and Credit data to show consumers easing back slightly after a bumper July.

The pace at which consumers took on new credit will probably slow from £2.0bn to £1.9bn. This is likely to reflect some payback after a strong July, when consumer credit rose to a five-month high and GDP surged by 0.3%. More broadly, consumers continue to borrow at a healthy pace while reducing their savings to keep spending growth ticking over.

Elsewhere, we expect mortgage approvals to tick up from 56,000 to 58,000, based on the improvement in the new buyer enquiries balance in the RICS survey. Even so, approvals will remain somewhat subdued as higher mortgage rates and stagnant real incomes squeeze affordability and prompt households to postpone purchases. Indeed, mortgage approvals were already down 14.9% year on year in July.

All told, we expect August’s Money and Credit data to show households continuing to smooth the impact of higher inflation through lower savings and solid borrowing flows. However, inflation is likely to rise above 4% in the new year and remain sticky through 2027. That more persistent shock increases the risk that consumers pull back on spending, dragging on growth.

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