Reeves must raise tax and cut spending, markets say

U.K. Finance Minister Rachel Reeves is walking a tightrope as her critical Autumn Budget looms, as pressure mounts to appease voters, shore up public finances and convince money markets her policies are sound.

Thanks to her self-imposed fiscal rules, which she has doubled down on in recent weeks, Reeves has been left scrambling to find strategies that can plug a multi-billion-pound hole in public finances by the time she delivers the budget on Nov. 26.

That means drastically cutting spending or breaking a manifesto pledge not to raise certain taxes — or a combination of the two.

CNBC takes a look at some of the options on the table.

The finance minister has been considering a range of ways to shore up public finances, according to recent reports from local media outlets, including taxing dividends, cutting tax breaks for salary sacrifice schemes and imposing higher levies on certain professions.

Any move to raise taxes would be unpopular.

A September YouGov poll of more than 6,500 Brits found almost one in three adults believes Reeves should avoid raising taxes in the budget, even if it means cutting spending or borrowing more. A separate YouGov poll found that more than half of 3,980 British adults believe Reeves should prioritize keeping the government’s promises not to hike taxes over pledges not to ramp up borrowing.

However, some within money markets would welcome tax hikes. On Friday, gilts sold off as investors reacted to reports that Reeves would U-turn on income tax rises that had been planned as part of the budget.

“How can this statement simultaneously promote growth whilst having to cut spending and increase the tax burden to keep bond investors happy?” Toni Meadows, head of investment at BRI Wealth Management, told CNBC at the time.

Brian Mangwiro, managing director of global sovereign debt and currencies at Barings, told CNBC his team is expecting Reeves to announce some form of tax rises at the budget later this month — a move that he said will be positive for U.K. government bonds, otherwise known as gilts.

Barings is taking a constructive stance on gilts amid a loosening labor market, softening wage growth, hopes that inflation is peaking and an assumption that the Bank of England will continue to cut interest rates through 2026.

“A fiscally responsible Budget will be an additional tailwind,” Mangwiro said by email. While he argued that the U.K.’s tax burden will likely rise to new records, Mangwiro said he expected financial markets to be a beneficiary of new or increased duties.  

“We expect additional revenues to be channeled towards investments given the government’s pro-growth agenda,” he said. “This will hopefully raise the U.K.’s productivity over the medium term.”

Stuart Edwards, who manages Invesco’s Tactical Bond Fund, also believes Reeves will deliver a “market friendly” Budget on Nov. 26.

“In the U.K., the chips are lining up for a more bond-friendly environment,” Edwards said at a recent fixed income roundtable. Edwards said the government and fiscal authorities in the U.K. now “recognize the situation” and have to “play it sensible” with public finances.

“They don’t have the bandwidth to play fast and loose,” Edwards said.

The U.K. gilt market has been buffeted by episodic bouts of volatility and uncertainty since former Prime Minister Liz Truss’s mini-budget in September 2022. “The gilt market has been volatile,” Edwards said. “But there has been value in gilts, there is a lot of risk premium embedded in gilts.”

Many bond investors who spoke to CNBC said they wanted to see Reeves combine tax hikes with spending cuts to help bring the spiraling public deficit under control.

“Gilt markets need to see genuine fiscal consolidation, delivered in a way which is not destructive to growth. This is a difficult balance,” said Emma Moriarty, portfolio manager at London’s CG Asset Management.

Some of this, she said, would have to come via broad-based tax hikes that take immediate effect – but Moriarty said it was crucial these are paired with “meaningful cuts” to expenditure.

The Autumn Budget comes as Reeves looks to plug a fiscal black hole estimated to be as high as £50 billion ($65.6 billion).

Slashing spending too drastically would also be unlikely to garner much support from the governing Labour party’s more left-leaning lawmakers, whose rebellion against an earlier attempt by Reeves to cut the country’s welfare bill led to her reforms being watered down over the summer.

“Closing a black hole of the current size entirely through taxation has the potential to weigh on economic growth for some time – not just through the direct hit to disposable income, but though the subtler behavioral impacts on the household savings rate and on the level of private investment, both of which have already been problems in the U.K. for some time,” Moriarty said.

“There is already a lot of good news priced into gilt markets,” she added, noting that gilt yields had fallen drastically across the curve over the past month.

“Most of this will be driven by positive sentiment from U.S. bond markets, but some of it will be due to increased market expectation that [Reeves] will take meaningful action to improve public finances. So, there is huge potential for these high expectations to be disappointed.”

Despite this, Barings’s Mangwiro said markets were likely to be disappointed on this front. “Given political sensitivity, we do not expect the Chancellor to announce significant spending cuts,” he said.

Another option available to Reeves is breaking her own fiscal rules, under which day-to-day government spending must be funded by tax revenues rather than borrowing, and public debt must be falling as a share of economic output by 2029-30.

That seems unlikely, however, after she used a surprise pre-budget speech last week to reiterate that her commitment to those rules is “iron-clad.”

Veering off course from the terms set out by her own rules would also be likely to rattle the influential bond market, which has responded negatively to suggestions that Reeves’s commitment to bringing Britain’s finances under control could be jeopardized.

Earlier this year, questions over Reeves’s future within the government sent gilt yields soaring, while yields also edged higher on Tuesday amid rumors that Prime Minister Keir Starmer’s leadership was under threat.

Maxime Darmet, senior economist at Allianz Trade, told CNBC that any deviation from Reeves’s fiscal rules could shake the gilts market.

“Gilt yields could be forced up if … the chancellor unexpectedly decides to reduce its fiscal headroom against the fiscal rules, while having previously called for an increase [or she changes] the fiscal rules, which could be perceived as a waning commitment to fiscal discipline,” Darmet said.

Yields could be driven higher if a negative political reaction to the budget leads to calls from lawmakers within her own party for Reeves’s resignation, Darmet said.

Bond yields and prices move in opposite directions, so when investors are reluctant to lend to a government, the price of the bond falls and the yield rises.

The U.K. government currently has the highest borrowing costs of any G-7 nation, with its 30-year gilt yield trading well above the critical 5% threshold and spending much of this year at multi-decade highs.

Dramatic rises in gilt yields — essentially the amount of interest the government pays on its debt — could also have a wider impact on the overall economy.

While bond yields reflect borrowing costs for the governments who issue them, they can also affect mortgage rates, investment returns, the wider economy and personal borrowing.