Reeves' Risky UK Gamble Will It Pay Off?

CNBC's UK Exchange: No Easy Answers for Reeves

Today's spending review has taken on extraordinary importance, reflecting the current turbulent state of U.K. politics. What should be a routine event, where the Chancellor of the Exchequer outlines the government's spending plans, is being seen by some as a defining moment for Prime Minister Keir Starmer's struggling administration.

Little under a year after securing a landslide victory, the government is grappling with unpopularity and urgently seeking ways to appease a discontented public. But what exactly can we expect from this pivotal review? Let's break it down:

What to Expect (and Not Expect)

• Not a Fiscal Event: Chancellor Rachel Reeves is committed to just one major fiscal event annually – the Autumn Budget. Therefore, no forecasts from the Office for Budget Responsibility will be unveiled today.
• No Immediate Tax Policy Changes: Don't anticipate any alterations to tax policies or significant changes to the overall government spending sums already outlined.
• The "Spending Envelope": Reeves previously set the spending parameters last October. Day-to-day spending (e.g., public sector salaries) is slated to rise by an average of 1.2% in real terms over the next three years. Capital spending (e.g., transport infrastructure) will increase by 1.3% over four years.

However, this tight spending envelope is raising concerns. Most economists believe Reeves' fiscal rules – covering day-to-day spending with tax revenue and reducing debt as a proportion of GDP – are under serious threat. Her last Budget left her with just £9.9 billion ($13.4 billion) of wiggle room, and since then, the economic outlook has worsened, and government borrowing costs have risen.

As the Institute for Fiscal Studies (IFS) notes, this is the "first multi-year spending review since 2021 and the first to happen outside of a pandemic since 2015." Even though it's not a formal fiscal event, the bond markets will be keenly watching for clues on taxation and borrowing strategies for the autumn.

U-Turns and Leaks: A Glimpse into the Review

A recent U-turn on the winter fuel allowance – a decision to means-test the benefit for pensioners – offers a telling insight. The reversal, costing £1.5 billion annually, highlights the government's struggle to make tough decisions and find savings. No details were given on where the money will come from.

Other key points emerging from leaks include:

• NHS Boost: The National Health Service (NHS) is expected to receive a 2.8% real-terms increase to its day-to-day budget over the next three years, potentially equivalent to an extra £30 billion by 2028. The big question is whether this will translate to improved patient services or be consumed by pay demands.
• Defense Spending: Defense appears to be the other major beneficiary, potentially absorbing the entire increase in capital spending. The government is committed to increasing defense spending from 2.3% of GDP to 2.5% by 2027 and 3% by the early 2030s. Pressure is mounting to reach 5%, as suggested by the Trump administration and NATO Secretary-General Mark Rutte which would need extra £24 billion to take defense spending to just 3% of GDP.

These substantial commitments, especially for the NHS (which already accounts for a significant portion of government spending), will inevitably lead to real-term cuts in other departments already strained by years of austerity.

Facing the Squeeze

Several sectors are feeling the pressure:

• Justice System: From courts to prisons, the justice system is struggling.
• Local Government: Facing rising costs and an ageing population, local governments are burdened with social care responsibilities.
• Schools: Despite some new funding, schools are expected to cover a substantial portion of teacher pay rises from existing budgets.

Reports also suggest cabinet disagreements over budget allocations, with energy, housing, and policing portfolios facing potential cuts.

The Productivity Puzzle

The core issue lies in the need for the British state to achieve greater efficiency. Sanjay Raja, senior U.K. economist at Deutsche Bank, points to the "sustainability in maintaining such tight spending envelopes, via ambitious cost-saving measures" and the challenges posed by higher interest rates and potential downgrades to productivity growth.

The U.K.'s public sector, particularly the NHS, has a concerning productivity record. For example, the NHS spent £102 million on postal letters last year, causing missed appointments, despite the potential for digital communication.

In the absence of productivity improvements or economic growth, future spending increases will require either increased borrowing or taxation. Chancellor Reeves' commitment to fiscal rules makes borrowing less likely, leading to speculation about potential tax increases in the autumn. Many economists, including Raja, believe tax rises are "inevitable" due to the emergence of a £10-15 billion fiscal hole ahead of the Autumn Budget.

The government's inability to make even modest spending cuts, as evidenced by the winter fuel allowance reversal, further fuels concerns about long-term fiscal sustainability.

A Rabbit from the Hat?

Despite the pre-announced nature of most decisions, Reeves may attempt a surprise announcement. Abolishing the cap restricting child benefits to the first two children in a family, costing £3.5 billion, would be a popular move. A more significant surprise would be an increase in the overall spending envelope. But without a clear funding plan, such a move would likely trigger a negative market reaction.

Ultimately, Chancellor Reeves faces a monumental challenge. Navigating this spending review requires balancing fiscal responsibility, political pressures, and the urgent needs of a nation grappling with economic uncertainty. The coming months will be crucial in determining whether she can find a path forward that satisfies both the markets and the public.

--Ian King

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Source: https://www.cnbc.com/2025/06/11/cnbc-uk-exchange-newsletter-rachel-reeves-spending-review-in-focus-.html