The £40bn question: How will Rachel Reeves balance the books?

Chancellor boosted by a surprise drop in inflation after the cabinet is warned she may need to find £40bn in taxes and borrowing in her Budget, dwarfing previous estimates of the fiscal ‘black hole’

Rachel Reeves is being warned that she may have to break Labour’s manifesto pledge not to raise income tax or national insurance in order to fill a £40bn black hole in her spending plans.

The concerns come after the chancellor warned her cabinet colleagues this week that she needs to find spending cuts and tax rises of £40bn to balance the books – far more than the £22bn she has claimed the Tories left behind.

Ms Reeves was boosted on Wednesday by a drop in inflation to 1.7 per cent – the first time in three years it has been under 2 per cent – which means benefit payments will not need to be raised by as much as feared. However, it also means she will not raise as much money as hoped from freezing income tax band thresholds.

The conundrum has led to speculation that Ms Reeves will unveil a £25bn tax raid in her Budget on 30 October, while spending on benefits and even international aid, traditionally protected by Labour, are under threat.

Keir Starmer and the chancellor must decide how to meet a £40bn black hole (Getty)

Already she has controversially taken away winter fuel payments from 10 million pensioners amid a plethora of cuts to balance the books after taking over from the Tories at a time when she has also been trying to meet the wage demands of the public sector.

But in a stark warning, Institute for Fiscal Studies (IFS) director Paul Johnson said she will struggle not to break Labour’s commitment to leave income tax and national insurance at their current rates.

He warned that “in the end [Labour] will have no choice but to raise income taxes”.

He told BBC Radio 4’s Today programme: “If we get tax rises on that scale it would be extraordinary, it would be unprecedented. That would be tax rises three times as big as George Osborne introduced back in the depths of the aftermath of the financial crisis.

“That said, if you are a government not only wanting to protect public services but also a significant increase on the health service and increased spending on other things in line with the size of the economy, yes, there is a very big hole in the public finances.

“Of course, we have always known this. We have had this discussion through the election when we were warning there were these problems, and Keir Starmer and others were saying ‘no, no, no there isn’t’. £40bn is a big number.”

The warning came after Ms Reeves’s former boss at the Bank of England, ex-governor Mervyn King, called on her to hike national insurance even though Labour had promised to freeze it. There is speculation Ms Reeves will keep the employee contribution on national insurance as it is but raise the contribution paid by employers.

Mervyn King, former Bank of England governor, has suggested increasing national insurance (PA)

But falling inflation could give the chancellor a further boost by making it more likely the Bank of England will cut interest rates again in November to 4.75 per cent.

Governor Andrew Bailey had previously indicated a desire to bring rates down, saying earlier this month that rate cuts could become “more aggressive” if needed.

Chief Treasury secretary Darren Jones said: “There is still more to do to protect working people, which is why we are focused on bringing back growth and restoring economic stability to deliver on the promise of change.”

But his Tory opposite number Laura Trott hit back, saying the figures “show Labour inherited a strong economy, thanks to the difficult decisions we took to tackle inflation when it was at its peak”.

Chief Treasury secretary Darren Jones stressed the importance of protecting ‘working people’ (Getty)

September’s inflation figure is used by the government to decide a number of tax and spending changes for next year, and means state benefits will rise by just 1.7 per cent next year. Due to the triple lock, the state pension will rise by more than double that amount – jumping by 4.1 per cent.

The Office for National Statistics’ chief economist Grant Fitzner said: “Lower airfares and petrol prices were the biggest driver for this month’s fall. These were partially offset by increases for food and non-alcoholic drinks, the first time that food price inflation has strengthened since early last year.”

Rampant inflation in previous years has caused everyday costs to spiral, with the Consumer Prices Index (CPI) measure hitting a record 11.1 per cent in October 2022. The latest figure marks a return to more usual inflation, but still remains higher than rates in early 2021, which were often below 1 per cent.

David Murray, financial planning expert at abrdn, said: “All signs were pointing to a decline in inflation in September, so to see rates continue a downward trend to 1.7 per cent – the first time inflation has been below the government’s 2 per cent target in more than three years – will be a huge relief.

“This will leave many hoping for a cut to interest rates next month, meaning we’d see two cuts before the end of the year, with some even suggesting that the base rate will be brought down to 4.5 per cent.”