Rachel Reeves faces painful spending cuts or higher taxes as economic forecasts downgraded

Rachel Reeves Faces Fiscal Headwinds as Economic Forecasts Plummet

Overly Optimistic OBR Projections Threaten Spending Cuts or Tax Hikes

City experts have raised concerns that the Office for Budget Responsibility (OBR) has significantly overestimated the UK economy's growth potential. Their forecasts suggest that the OBR will be forced to revise its predictions downwards significantly in the upcoming March update.

The downgraded forecasts pose a significant threat to Chancellor Rachel Reeves's finely balanced Budget, which already faces pressure due to rising borrowing costs. As a result, spending cuts or tax increases appear increasingly likely alongside the Spring Statement.

Weak Growth Forecasts Cast Shadow Over Fiscal Plans

The OBR predicted in October that the economy would expand by 2% this year. However, City economists expect growth of just half that rate in 2025, according to private sector projections. This follows a period of sustained weakness since Labour assumed power.

Growth remained stagnant in the previous quarter and reached just 0.1% in the final months of 2022. City economists expect this underperformance to persist into 2026, with growth forecasts of 1.4%, below the OBR's 1.8% projection.

Productivity Lag Weighs on Budget

Another concern is weak productivity growth. The OBR anticipates output per hour worked to increase by 0.9% this year and 1.1% by 2026. Private sector forecasts, however, predict growth of only 0.6% and 0.9%, respectively.

Productivity has been lagging in the UK since the financial crisis, and recent data suggests it continues to struggle. A 0.1 percentage point downgrade in productivity growth costs the Chancellor approximately £7 billion, potentially creating a £20 billion budget gap if private sector forecasts prove accurate.

Reeves Faces Difficult Fiscal Choices

As a result, Chancellor Reeves may face the need to raise taxes or cut spending to balance the public finances and meet fiscal rules. Michael Saunders, a former member of the Bank of England's Monetary Policy Committee, estimates that the government would need to implement £20 billion in fiscal tightening to maintain a £9.9 billion fiscal headroom.

Rising Inflation and Pay Growth Offer Some Relief

While the downward revision in growth forecasts presents challenges, other factors may provide some respite for the Chancellor. Inflation has risen to 3%, and the Bank of England expects it to reach 3.75% later this year. This could generate increased VAT receipts for the government.

Additionally, City economists anticipate higher pay growth than the OBR predicts, with earnings expected to rise by 3.5% this year and 3.1% next year, significantly above the official forecast of 2.3% and 2.1%, respectively. These pay rises may push more workers into higher tax brackets, providing additional revenue.

OBR Forecasts Under Scrutiny

Critics have questioned the OBR's overly optimistic growth and productivity forecasts, citing a history of overestimating these indicators. Saunders emphasizes that the OBR's productivity forecasts should be based on a structural analysis rather than a speculative hope for recovery.

The OBR is currently preparing its updated forecasts, which will be presented to the Treasury on Wednesday. These projections will significantly influence the Chancellor's fiscal plans and the potential for spending cuts or tax increases in the near future.