IFS warns inflation poses greater threat to fiscal headroom than borrowing costs

The Institute for Fiscal Studies has warned that soaring inflation presents a more significant challenge to the government’s finances than rising borrowing costs. The think tank suggests that the Chancellor may need to commit to an additional thirty-five billion pounds in spending by the end of the decade to prevent the real value of departmental budgets from being eroded. This finding indicates that the primary fiscal headache for the government is not the narrowing of available headroom, but the pressure to maintain public service funding in the face of persistent price increases.

According to the IFS, higher interest rates on government debt are expected to increase borrowing by approximately ten billion pounds in the 2029-30 financial year. However, this increase is largely offset by higher tax revenues generated by rising inflation. Consequently, the government’s fiscal headroom is projected to be around twenty billion pounds in 2029-30, a softer decline than the twenty-four billion pounds forecast in March. Despite this relative stability in headroom, the think tank argues that the erosion of real-terms spending remains the critical issue that the Chancellor must address directly in the upcoming Budget.

The IFS states that the government faces a difficult choice between accepting real-terms cuts to public services or committing to increased spending to avoid such reductions. If the Chancellor chooses to top up departmental budgets, the think tank estimates this would require tax rises or benefit cuts of around thirty-five billion pounds. Helen Miller, director of the IFS, emphasised that the Chancellor must set out spending envelopes that are genuinely sustainable. She warned that pencilling in implicit cuts with no intention of delivering them would render the Budget a work of fiction and undermine the credibility of the government’s plan to meet fiscal rules.

This analysis arrives as the Chancellor prepares to attend an International Monetary Fund summit in Bangkok, where he aims to demonstrate to international allies that the UK is committed to controlling borrowing. The context is complicated by rising costs linked to the Iran war, which have prompted calls for increased support for the cost of living. BDO’s inflation index rose to 103.65 in September, its highest reading since June 2023, while its output index fell to 99.19, indicating that rising costs and weakening consumer confidence are impacting British firms. The Chancellor has stated that his Budget will focus on fiscal discipline to deliver economic resilience, aiming to provide breathing space for the present and hope for the future.