Reeves needs to raise taxes and cut spending, market says

Britain’s Chancellor of the Exchequer Rachel Reeves is walking a tightrope as pressure mounts to appease voters, shore up public finances and convince money markets that her policies are sound as the crucial autumn budget approaches.

Thanks to the self-imposed fiscal rules he has tightened in recent weeks, Mr Reeves is busy finding a strategy to plug the multi-billion pound hole in his public finances before the Budget is tabled on November 26.

That could mean sharp cuts in spending, breaking manifesto pledges not to raise certain taxes, or a combination of the two.

CNBC looks at some of the options on the table.

According to recent reports in local media, the finance minister is considering various ways to strengthen public finances, including taxing dividends, reducing tax breaks for salary sacrifice schemes, and imposing higher levies on certain professions.

The move to raise taxes would be unpopular.

A YouGov poll of more than 6,500 Britons in September found that almost one in three adults thought Mr Reeves should avoid raising taxes in the budget, even if it meant cutting spending or increasing debt. A separate YouGov poll found that more than half of 3,980 British adults think Mr Reeves should prioritize keeping the government’s promise not to raise taxes over his pledge not to increase borrowing.

However, some in the money market welcome the tax increase. Gold sold off on Friday as investors reacted to reports that Mr. Reeves would reverse course on the income tax hike planned as part of his budget.

“How can this statement simultaneously drive growth while we need to cut spending and increase tax burdens to satisfy fixed income investors?” Toni Meadows, head of investments at BRI Wealth Management, told CNBC at the time.

Brian Mangwilo, managing director of global government bonds and currencies at Barings, told CNBC that Reeves’ team expects to announce some form of tax increase in the budget later this month. The move is positive for British bonds, also known as gilts, he said.

Barings has taken a constructive stance on British debt, with the labor market easing, wage growth slowing, expectations that inflation has peaked and the Bank of England continuing to cut interest rates until 2026.

“A fiscally responsible budget proposal would provide further support,” Mangwiro said in an email. Mr Mangwiro argued that the UK’s tax burden was likely to hit a new record, but said he expected financial markets to benefit from any new or increased tariffs.

“Given the government’s pro-growth policies, we expect additional revenue to be channeled into investment,” he said. “This is expected to increase productivity in the UK over the medium term.”

Stuart Edwards, who runs Invesco’s Tactical Bond Fund, also believes Reeves will deliver a “market-friendly” budget on November 26.

“The chips are lining up for a more bond-friendly environment in the UK,” Mr Edwards said at a recent bond roundtable. Mr Edwards said the UK government and financial authorities were now “aware of the situation” and needed to “tack wisely” with public finances.

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

The UK gold market has been plagued by blips of volatility and uncertainty since former chancellor Liz Truss set out her mini-Budget in September 2022. “The gold market is volatile,” Edwards said. “But gilt has value, and gilt has a huge risk premium built into it.”

Many bond investors interviewed by CNBC said they want Reeves to use a combination of tax increases and spending cuts to rein in the soaring public deficit.

“The gilt market needs to achieve real financial health in a way that doesn’t destroy growth. This is a difficult balance,” said Emma Moriarty, portfolio manager at CG Asset Management in London.

She said some of this would need to come through broad-based tax increases that would be implemented immediately, but Moriarty said it was important that these were combined with “meaningful cuts” to spending.

The autumn budget comes as Mr Reeves seeks to plug a fiscal black hole estimated at up to 50 billion pounds ($65.6 billion).

If spending is cut too drastically, it is unlikely to gain much support, even from left-wing members of the ruling Labor Party. Mr. Reeves has pushed back against previous attempts to cut the welfare bill, and his reforms were watered down over the summer.

“Filling a black hole of its current size entirely through taxation could weigh on economic growth for some time, not only through the direct hit to disposable income, but also through the subtle effects of the action on household savings rates and levels of private investment, both of which have been problems in the UK for some time,” Moriarty said.

“There’s a lot of good news already priced into the gold market,” he added, noting that gold yields have fallen significantly across the curve over the past month.

“Much of this will be driven by positive sentiment in the U.S. bond market, but some of it will be driven by rising market expectations that Mr.

Nevertheless, Barings’ Mangwilo said the market is likely to be disappointed on this front. “Given political sensitivities, we do not expect the Prime Minister to announce significant spending cuts,” he said.

Another option available to Mr. Reeves is to break his own fiscal rules. Under the rules, day-to-day government spending must be financed by tax revenue rather than borrowing, and public debt as a share of economic output must fall by 2029-30.

But that seems unlikely after she reiterated in a surprise speech before the budget last week that her commitment to these rules was “ironclad”.

It is also likely to upset the influential bond market, which has reacted negatively to suggestions that Reeves’ efforts to keep Britain’s finances under control could be jeopardized if he strays from his own terms.

Gold yields soared earlier this year as questions arose within the government over Reeves’ future, but they rose slightly on Tuesday as rumors emerged that Prime Minister Keir Starmer’s leadership was under threat.

Maxime Dame, senior economist at Allianz Trade, told CNBC that Reeves’ departure from fiscal rules could shake up the gold market.

“Gold yields could be forced to rise if the chancellor unexpectedly decides to cut fiscal space in violation of fiscal rules, despite having previously called for them to be raised (or changed), which could be perceived as a weakening of the commitment to fiscal discipline,” Dahme said.

Mr Dermett said yields could rise if negative political reaction to the Budget led to calls from members of his own party for Mr Reeves to resign.

Bond yields and prices move in opposite directions, so if investors are reluctant to lend to the government, bond prices will fall and yields will rise.

The UK government currently has the highest borrowing costs of any G7 country, with 30-year bond yields well above the critical 5% threshold, spending much of this year at multi-decade highs.

A dramatic rise in gold yields (essentially the amount of interest governments pay on their debt) could also have far-reaching effects across the economy.

While bond yields reflect the cost of borrowing for governments that issue bonds, they can also affect mortgage rates, investment returns, the broader economy, and personal borrowing.