Burnham’s funding gap: what state are UK finances in for the PM-in-waiting? | Economics

An economy reeling from a global energy shock, jittery bond markets and rising spending demands. Pressures on public finances are at the forefront as Andy Burnham prepares to enter government.

The future prime minister this week promised a new direction for Britain within two constraints: sticking to Labour’s existing fiscal rules and being consistent with its 2024 manifesto.

Burnham will have a formidable starting position even before her anticipated arrival at Downing Street.

The latest reference point for how much leeway Burnham might have as prime minister when it comes to adherence to fiscal rules drawn up by Rachel Reeves was set out in the chancellor’s spring statement in March.

Reeves left himself with £23.6bn of “headroom” in breach of his financial rules’ requirement to balance day-to-day expenses with income over a five-year period.

But since then, the impact of the Iran war on the UK economy, rising government borrowing costs and Keir Starmer’s defense investment plan have likely exhausted some of that buffer.

The outgoing prime minister this week announced an additional £15 billion in defense spending over four years, but did not give full details of how this would be financed.

According to the Treasury, £10.3 billion will be raised by “budget reallocation” between government departments. But many of the decisions on how these budgets will change have not yet been made, creating a headache for the new prime minister. A further £4.7bn will also need to be set aside in the autumn budget, a deficit of around £1.2bn a year.

However, extra expenses can be covered without breaking financial rules.

It will be up to the Office for Budget Responsibility (OBR) to decide on this issue, which will need to take into account a range of headwinds and headwinds for the public finances, well beyond the extra costs introduced by Starmer’s defense investment plan.

The most important of these is the impact of the Iran war, which increased inflation and put pressure on economic growth. As a reflection of this economic change – and as the Bank of England keeps interest rates steady – the government’s borrowing costs have increased and the bill to service the UK’s £2.9 trillion national debt has increased.

But the Treasury is expected to tell Burnham within days, according to the Financial Times, that the war has done less damage than first feared and has made only a modest dent in the vacuum left by Reeves.

It reported that Capital Economics had estimated as recently as May that the war could wipe £10bn out of the Chancellor’s share of £23.6bn, but now expects little change in the OBR assessment following the collapse in global oil prices and bond yields since the height of the Middle East crisis.

How much leeway Burnham has will depend in part on how the Bank of England responds. It will also depend on whether the prime minister-in-waiting can avoid provoking a negative reaction from the bond market. City investors will be watching his choice of chancellor closely.

So far, Burnham’s pledge to stick to fiscal rules has kept bond markets quiet. Yields moved little after Monday’s sensational speech.

But the government will face the challenge of financing additional spending on emergency energy support, as well as the new policies Burnham wants to pursue. In this context, analysts at Swiss bank UBS say that an important question will be whether it will be necessary to look at tax increases in the autumn budget.