Why has fiscal headroom narrowed?

  • The UK's Office for Budget Responsibility (OBR) raised its wage forecasts, but rising debt interest costs and recent downgrades to GDP growth forecasts had a larger impact, pushing up borrowing forecasts.
  • After accounting for new measures and changes in economic forecasts, the OBR raised its deficit estimates over the forecast period by an average of £13 billion a year, close to Goldman Sachs' earlier estimate of £12 billion.
  • The government's headroom against its deficit rule fell from £24 billion to £15 billion, in line with market consensus and close to Goldman Sachs' estimate of £16 billion.

How does the new budget affect borrowing and the economy?

  • The government introduced a modest package of tax increases, expected to raise about £6 billion a year by the fiscal rule's target year of 2029/30. Sources include stronger tax compliance, adjustments to corporate and bank taxes, and higher taxes on savings and property income.
  • At the same time, the government introduced temporary cost-of-living support and funded the remainder of its defence investment plan. The OBR expects all new policies combined to increase borrowing by £6.3 billion in 2026/27 and £7 billion in 2027/28, respectively, but to reduce the deficit slightly from 2029/30 onward.
  • Goldman Sachs believes the new measures will have a limited effect on aggregate demand; the OBR judged the demand-side impact too small to include separately in its GDP forecast. The fuel duty cut and the VAT relief on electricity bills have been extended until July and are expected to lower headline inflation in early 2027, though the effect will be modest.

Why did the higher deficit forecast not produce an equal increase in cash requirements?

  • Compared with the OBR's March forecast, the government's cash requirement was revised up by £7 billion in the current fiscal year and by an average of £4 billion a year over the forecast period, less than the upward revision to the deficit forecast.
  • Part of the difference comes from higher inflation increasing accrued interest on inflation-linked bonds, which raises the deficit without producing an immediate cash outlay. The government is covering the additional £7 billion cash requirement in 2026/27 by increasing gilt issuance by £4 billion and financing £3 billion through short-term bills.

Where will pressure on next year's spending review come from?

  • Although the deficit forecast is higher than in March, the latest plans still imply a significant decline in the deficit over the coming years. Meanwhile, some spending pressures remain unresolved: from 2027/28, real growth in day-to-day departmental spending will slow to 0.8%, while the health budget is growing faster and defence spending is planned to rise to 3% of GDP by 2030.
  • Goldman Sachs believes historical experience suggests next year's spending review could substantially increase spending plans, but the narrower headroom against the deficit rule will make additional spending harder to finance.

What changes could ease the fiscal trade-offs?

  • The fiscal rule's target year in next autumn's budget will move forward to 2030/31. The OBR expects the current budget balance in that year to improve by £7 billion relative to 2029/30, potentially creating more fiscal headroom; the government could also consider allocating more of the increase in defence spending to capital expenditure, using the larger buffer under the debt rule.
  • Improved economic forecasts could also help. The OBR expects GDP growth of 1% in 2027, below Goldman Sachs' forecast of 1.5%; Goldman Sachs' interest rate forecasts are also lower than the assumptions used in the OBR's fiscal forecasts. If the economic environment does not improve, Goldman Sachs believes the government will still face difficult fiscal choices next year.