UK fiscal outlook deepens into a 'fiscal quagmire', further tax rises are 'inevitable'

We have warned in the last couple of years that Britain faces the real prospect of becoming stuck in a self-defeating fiscal doom loop, whereby tax hikes needed to shore up the public finances choke off the growth required to fund them. Now, there are defensible arguments to suggest that we’re not in a perpetual cycle in the strictest sense - gilt auctions continue to clear without difficulty and growth has proved more resilient than feared.

As such, we’re instead framing this as more of a fiscal quagmire, reflecting political choices that are crowding out private investment and deepening the hole with every attempt to climb out.

This year’s fiscal arithmetic has, of course, been complicated by global factors, namely the war in Iran, which continues to drag on for far longer than anticipated. Brent crude oil prices are continuing to trade above $100 a barrel, while gilt yields have risen in line with the broad sell off in government debt - both the 10-year and 30-year are trading at multi-decade highs.

This is a multi-faceted problem for the government, as not only do higher oil prices have inflationary and growth implications, but the jump in yields has eroded the fiscal headroom - the cushion provided to account for market fluctuations.

With yields surging, borrowing running ahead of the OBR's forecasts, debt-servicing costs climbing and the headroom eroding fast, we think that additional tax hikes are inevitable. By most estimates, the rise in borrowing costs has cut Chancellor Healey’s fiscal headroom in half from £23.6 billion in the spring to around the £12-13 billion range, though the FT puts this as low as £8.5 billion.

There have been reports in the last few weeks that the Treasury may be willing to accept a thinner fiscal buffer to limit the need to tinker with the public finances, though bond traders are fickle and could punish both gilts and sterling should this headroom be deemed as insufficient in order to absorb future shocks.