UK fiscal headroom remains largely intact as Burnham prepares for Budget choices

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UK fiscal headroom and Budget

Highlights

Internal Treasury assessments indicate the £23.6 billion UK fiscal headroom remains largely intact, with limited impact from the Iran war and no immediate tax hikes required.
Market concerns have eased as oil prices fell, with headroom projections stabilizing around £13–17 billion assuming Bank of England rate cuts next year, despite borrowing to May reaching £46.3 billion.
Planned increases in council housing, infrastructure, and defence spending—including an ambition to raise defence to 3.5% of GDP by 2035—pose significant fiscal pressure for Burnham's incoming government.

Treasury briefing shapes fiscal outlook

As reported by Financial Times, Treasury officials are due to brief Burnham's team in the coming days as part of access talks, with current internal thinking suggesting the impact of the Iran war on the public finances is limited. People briefed on that assessment say the hit to the £23.6 billion headroom is modest, meaning a new government does not need to raise taxes simply to repair damage from the energy crisis, although it may still choose to do so to fund new spending commitments.

Burnham is expected to become prime minister on July 20, and his advisers are already weighing how much room the next chancellor will have against the main fiscal rule, which requires the current budget, excluding borrowing for investment, to be in surplus by the end of parliament. Lord Jim O'Neill, Burnham's economics adviser, has this week urged against higher taxes on business and instead backed spending restraint and a more flexible reading of the fiscal rules.

Market concerns have eased since the height of the Iran crisis, helped by lower oil prices. Capital Economics estimated in mid-May that weaker growth, higher inflation expectations, rising interest rates and higher gilt yields could cut more than £10 billion from headroom to about £13 billion, but economist Ruth Gregory now sees little change from the Office for Budget Responsibility's March forecast, assuming the Bank of England cuts interest rates sharply next year.

Other economists remain cautious. Rob Wood of Pantheon Macroeconomics says the next chancellor is likely to inherit headroom in the high teens, while Mahmood Pradhan of Bruegel says the near-term picture looks better than it did two or three months ago but the longer-term fiscal position remains fragile, especially after borrowing in the financial year to May reaches £46.3 billion, about £7.7 billion above the OBR forecast.

Spending plans keep pressure on the next government

Even if the fiscal backdrop is less severe than feared, Burnham still faces difficult spending choices. He has signaled that he wants to increase funding for areas including council housing and infrastructure, while also inheriting pressure to fund a new defence investment plan that outgoing prime minister Sir Keir Starmer leaves partly unresolved.

Starmer says the purpose of the headroom is to preserve credibility and allow decisions outside the Budget cycle, and he has indicated it could help fill the defence funding gap. But while Downing Street insists the wider £15 billion defence package is fully funded through capital budget reallocations, Burnham's administration still appears likely to decide where most of the planned £10.3 billion in cuts will fall, with fuller details not expected until autumn.

The longer-term burden is larger still. The government's ambition to raise defence spending to 3.5% of GDP by 2035 would require an additional £25 billion a year in today's terms, according to the Institute for Fiscal Studies, while support for struggling households on winter energy bills remains under consideration and a new chancellor must decide whether to proceed.

Another pressure point comes from public sector pay. The Department for Education announces that teachers' pay will rise by 3.5% on average from September, followed by a further 3% increase in September 2027, with schools expected to absorb about a third of the cost and the department providing £1.8 billion from its existing budget plus £485 million for further education providers.

Our earlier article on the UK’s Global Combat Air Programme (GCAP) funding outlined how the government boosted its allocation to £8.6bn over four years, supporting BAE Systems and partners in Italy and Japan as they push toward a next-generation fighter by 2035. We also noted that the funding under the Defence Investment Plan helped clear the way for an imminent longer-term international contract and highlighted how digital engineering is accelerating development milestones for the Tempest/GCAP demonstrator.

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