Why Rachel Reeves hopes the markets will swallow her Budget smorgasbord

No doubt to her relief, the cost of the chancellor’s substantial borrowings on behalf of the British people has subsided following a spike in gilt yields on Friday.

In what must be the most chaotic Budget preparation in history, the government has somehow contrived to end up in a worse position than if it had just delivered all the bad news a fortnight ago. The financial markets are still unsettled, exacerbated by a bit of tech sell-off and some fresh turmoil in crypto, and that’s a bad thing all round.

After the unprecedented “scene-setting” speech delivered by Rachel Reeves earlier this month, speculation mounted that she was going to raise income tax. Reeves said: “If we are to build the future of Britain together, we will all have to contribute to that effort, each of us must do our bit for the security of our country and the brightness of its future.” It was tantamount to a declaration of intent.

Investors care little for manifesto promises and are more concerned about whether a state can service its national debt. A hike in income tax represents an immediate, substantial and reliable increase in revenues. As expectations mounted, UK government debt became more popular, so gilt prices rose and the market rate of interest needed to keep them attractive fell. Politics aside, it was all looking fiscally good for Reeves.

She ditched the plan to raise income tax. Ironically, this was precisely because the Office for Budget Responsibility (OBR) lowered its projections for the cost of servicing the national debt over the next few years. But because the U-turn was briefed to the media, investors reacted badly and the net result was a spike in the gilt yield. It was nowhere near Liz Truss levels of panic, but unwelcome all the same. The alternative “smorgasbord” plan for smaller tax rises – on, say, gambling and property – is regarded as inferior to the income tax hike in terms of closing the black hole in the public finances.

Not quite back to square one. Market sentiment has settled down, and the OBR’s forecasts will be revised accordingly, but broadly it is more optimistic about factors such as wage growth, so the fiscal gap Reeves has to fill is still lower than previously judged – nearer to £20bn than £30bn or £40bn.

The most substantial measure will be a further freeze in the thresholds for the various rates of income tax; this is a tax hike, but is stealthy enough that people rarely seem to notice it. Paying the higher rate of income tax will become a reality for a lot more of Britain’s workers in the years to come.

Otherwise, there’s likely to be a pay-per-mile charge for electric cars, and a new council tax surcharge on the occupiers of relatively expensive homes – hundreds of pounds extra, reportedly, on homes in bands F, G and H. An online gambling levy is also planned, plus more freedom for mayors to levy a “tourist tax”. So someone in a fancy joint with a Tesla outside and a taste for a digital flutter might easily find themselves £1,000 a year worse off, even if they are part of what Labour calls a “working family”.

The downside of a wider range of smaller tax rises is that it offends a wider range of noisy vested interests, and risks some unexpected farce such as the notorious “pasty tax” that brought George Osborne such ridicule in the 2012 omnishambles budget.

Only if Reeves builds enough headroom into her plans so that she won’t have to come back yet again with more tax rises or spending cuts. This was one of her fundamental and persistent misjudgements in her first year. Politically, there’s a case for her building up a much bigger buffer to cope with the vicissitudes of a full five-year term – and to leave some scope for tax cuts before the next general election. With a total annual tax take of more than £1,000bn, a safety margin of £20bn ain’t much.

This is less likely. A clear line of division is developing here with the Conservatives and Reform UK. The parliamentary Labour Party has clearly shown its willingness to veto anything it doesn’t like, as with the scuppered benefits reforms. Reeves will also be unwilling to undo the multi-year departmental Comprehensive Spending Review announced last June. Still, they wouldn’t mind having another go at the social security budget.

No. That would break Reeves’s fiscal rules and, much more to the point, would further weaken market confidence and trigger a fiscal crisis.

If the smorgasbord option works and things go to plan, inflation and interest rates should gradually come down over 2026, better-funded public services should improve, and new infrastructure in areas such as transport and housing will start to become visible. Reeves might win some praise for limiting the two-child cap on child benefit and cutting VAT in fuel (as is speculated). But things will still be tight for the foreseeable future.