Iran Conflict Threatens UK Budget Plans, Think Tank Warns

Chancellor John Healey faces significant challenges in formulating his first Budget due to potential inflation spikes stemming from the conflict in the Middle East and Ukraine, according to a warning from the Institute for Fiscal Studies (IFS).

The influential think tank stated that higher-than-expected inflation could strain public service budgets, compelling Healey to consider spending cuts, tax increases, or a combination of both. The IFS urged the government to present credible spending plans rather than relying on unrealistic future reductions to balance the Budget.

"A 'steady-as-she-goes' Budget is not an option available to the chancellor," said IFS director Helen Miller. "Choosing to stay the course with the inherited tax and spending plans would mean allowing inflation to blow departments' spending plans off course. Simply pencilling in implicit cuts that he has no intention of delivering would make the Budget a work of fiction."

The Treasury has declined to comment on "rumour and speculation." However, Healey acknowledged the global impact of ongoing conflicts. "The consequences of conflict in the Middle East and Europe are hitting countries worldwide, leading to higher prices at the pumps and more expensive mortgages at home," he stated. He added that his Budget would "build on this approach with fiscal discipline helping to deliver economic resilience" and offer the public "breathing space."

The government is under pressure to demonstrate financial stability to markets amid rising borrowing costs. The wars in Ukraine and the Middle East have driven up global energy prices, contributing to increased costs for consumers and higher interest payments on UK government debt, further pressuring Healey.

While higher inflation can boost tax revenues, the IFS noted it also diminishes the real value of departmental budgets. The think tank estimates that recent market turbulence and elevated inflation could add approximately £10 billion to the government's borrowing costs by 2029-30, compared to earlier forecasts.

Despite these pressures, the IFS expects the government to meet its fiscal rules, which require borrowing only for investment by 2029-30 and reducing debt as a percentage of GDP, partly due to inflation-driven tax receipts. However, the buffer, or "headroom," available to meet these rules is projected to narrow to around £20 billion, down from the £24 billion forecast by the Office for Budget Responsibility (OBR) at the Spring Statement.

Recent market sentiment has suggested comfort with a reduced headroom. The IFS also anticipates any relief measures for households to be temporary and limited.

However, the IFS cautioned about the uncertainty of its forecasts in the current volatile environment. The OBR's official forecast, which Healey will rely on, might present a different outlook. The IFS calculated that to maintain departmental budgets against higher inflation, the government might need an additional £25 billion by 2029-30, excluding any planned increases in defense spending, which would imply significant tax rises.

The Chancellor is not obligated to finalize spending totals in this Budget and could defer these decisions to future events, such as next year's Spring Statement or Spending Review, when the economic outlook may be clearer. The IFS warned that failing to address inherited spending plans, which may not keep pace with inflation for some departments, could undermine the credibility of the government's fiscal strategy.