The government's 'fiscal headroom' is often presented as an indicator of the Budget’s credibility. But how useful is it a guide to the health of public finances or as a measure of the Budget’s success? Ahead of the Autumn Budget on 28 October, Professor Christopher Martin explores the limitations of this widely cited figure and explains why the UK’s longer-term economic and social challenges deserve greater attention.
Fiscal headroom is likely to feature prominently in the debate around the government’s first Budget under Prime Minister Andy Burnham. Yet it is neither a reliable measure of the Budget’s merits nor a comprehensive indicator of public finances. Implausible policy assumptions undermine the credibility of the forecasts underpinning this figure, with optimistic spending projections and uncertain future growth making the public finances appear stronger than they may prove to be.
An excessive focus on fiscal headroom risks narrowing the Budget debate to whether the government can meet its self-imposed fiscal rules. This distracts attention from the UK’s deeper economic and social challenges, including weak productivity, pressure on public services and the need to improve living standards. These challenges must also be considered in the context of Brexit, which continues to constrain the UK’s economic prospects. Closer relations with the EU deserve serious consideration as part of a wider debate about the country’s economic future.
Ultimately, the question is not simply how much fiscal headroom the government has, but whether its policies can address the structural challenges that are shaping the country’s future prosperity, while maintaining sustainable public finances.
Why fiscal headroom attracts so much attention
As Chancellor John Healey prepares to deliver the government’s first Budget under Prime Minister Andy Burnham, attention is turning to fiscal headroom. This figure shows how much margin the government has to meet its targets for borrowing and debt, according to the latest forecasts. A larger margin is generally seen as reassuring, while a smaller one can raise concerns about the risk of breaking fiscal rules. Broadly speaking, a fiscal headroom of around £15 billion or more is viewed positively.
Fiscal headroom also plays a role in the budgetary process itself. The government submits its tax and spending plans to the Office for Budget Responsibility (OBR), which assesses their likely effects on the economy and public finances. The OBR forecasts economic growth, inflation, government borrowing and public debt, and fiscal headroom, among other measures. The government can then revise its plans in response and, after some back-and-forth, the Budget is finalised and presented to Parliament, alongside the OBR’s assessment.
The UK Budget is large and complex. To simplify it, journalists and commentators often try to summarise it using fiscal headroom. This figure is therefore likely to dominate political debate in the coming weeks. However, its significance is often overstated.
There are two important reasons to treat fiscal headroom with caution.
Forecasts built on unrealistic assumptions
First, the budgetary plans contain fictions. They can rely on assumptions unlikely to be realised in practice. For example, government plans have often included fuel duty increases that were subsequently not implemented. The OBR forecasts on the assumption that these increases will take place, despite widespread doubts that they will.
Similarly, the budgetary plans contain projections for government spending. Currently, spending projections imply significant restraint over the coming years. Yet few expect such a squeeze on public spending to be sustained in the run-up to the next election.
These assumptions can increase forecast fiscal headroom, improving the fiscal outlook on paper without accurately reflecting future policy. This undermines confidence in longer-term fiscal forecasts.
What fiscal headroom does not tell us
The second reason to treat fiscal headroom with caution is because public debate can give the impression that fiscal headroom reflects the government’s ability to borrow, service its debts or pay for public services...
It does not.
Fiscal headroom is a narrow measure. It shows how far the government's plans are from breaching its self-imposed fiscal rule that public sector net financial liabilities (PSNFL) should be falling as a share of GDP by 2029-30.
An excessive focus on fiscal headroom risks distracting attention from wider economic and policy issues. To understand the choices facing the government, it is necessary to consider the broader political and economic context.
A government with ambitious plans
Andy Burnham has taken office amid considerable international uncertainty. He has said that the country faces a period of significant change and has set out an ambitious agenda, including greater public control over key services and a renewed focus on industrial policy. These proposals have attracted attention for their scale and long-term focus.
Several early proposals have received a broadly positive response from economists, including plans relating to pensions, social care and support for young people who are not in employment, education or training (NEET). The government has also indicated a willingness to explore closer relations with the EU, which could bring economic benefits depending on the terms and extent of any changes.
Nevertheless, translating these ambitions into sustained economic progress will be challenging. Changes to public services, skills, infrastructure and industrial policy may take years to improve productivity and living standards, and may require upfront investment. This illustrates the difficulty of not simply finding room in the Budget, but making choices that support long-term objectives while properly assessing their costs, risks and likely benefits.
A stronger economy than expected?
The economic legacy inherited by the new administration is mixed, but generally stronger than many anticipated. Although economic data can be difficult to interpret, the available evidence suggests the UK economy has performed relatively well over the past two years: growth has been around 2.5% over the previous 18 months. This was comparable to Canada and higher than in Germany, France and Italy, although below the US.
This performance exceeded many commentators expectations, particularly given the continuing economic constraints associated with Brexit.
Growth has also been accompanied by rising output per person, rather than being driven primarily by immigration and population growth, as during the Sunak administration. Investment has also increased significantly, providing a potentially positive foundation for future growth.
However, two uncertainties complicate the assessment of the economy's underlying strength.
The productivity debate
The first concerns productivity growth. There is growing, though still contested, evidence that productivity may be strengthening after years of weak performance. As a key driver of long-term improvements in living standards, this has generated considerable interest among economists. If the trend proves durable, it could improve the outlook for both the economy and public finances.
The uncertainty arises because different labour market measures tell different stories. Labour Force Survey (LFS) data suggest employment has risen significantly over the past two years, while tax data indicate more modest growth. Other evidence suggests average hours worked may have fallen as people take more holidays.
The case for stronger productivity growth depends largely on the latter measures proving more accurate. Many economists place greater weight on these data because the LFS has faced well-documented challenges since the pandemic. Nevertheless, it is too early to draw firm conclusions.
The challenge of government borrowing
The second uncertainty concerns government borrowing costs. Yields on 10-year UK government bonds have remained elevated, reflecting international developments, including the conflict involving Iran, and domestic fiscal pressures. Borrowing costs have risen in many countries, but they have generally remained higher in the UK than in some comparable economies. This adds to the cost of servicing government debt and complicates decisions on taxation and spending.
One factor is the UK's persistent fiscal deficit, which remains above 4% of GDP. Governments of different political colours have struggled to contain spending growth or close the gap between spending and revenue. The reductions in employee National Insurance contributions introduced by the Sunak government in late 2023 and early 2024 reduced expected tax revenues. Labour subsequently committed to retaining these cuts while in opposition, limiting the options available to the new government. The overall fiscal position also reflects wider economic conditions, spending decisions and other changes to taxation.
The government therefore faces difficult choices. Raising additional revenue could support public services and improve the public finances, but tax increases involve political and economic trade-offs. The challenge is to maintain confidence in sustainable borrowing while supporting the UK’s long-term economic prospects.
So, what might the new administration do against this backdrop?
Three audiences for the Budget
The government faces three important audiences as it prepares its Budget. The first is the public and the second is the bond market, which monitors the government's fiscal plans and wider economic conditions. The third is the OBR, whose assessment will help determine whether the government's plans are judged to be sustainable.
Policy decisions are increasingly shaped not only by how the OBR will “score” their impact on economic growth, borrowing and the fiscal outlook. Increasingly, economic policymaking resembles a three-way game between the government, the OBR and the bond market. Recent efforts to reform parts of the machinery of government may improve this, but they do not alter these underlying constraints.
The UK’s long-term policy challenges: Looking beyond the numbers
Two examples illustrate the consequences of long-standing policy failures. The prison system remains under considerable pressure despite historically low levels of many forms of crime. Meanwhile, spending on hospitals and urgent care continues to grow, although many health needs could be addressed more effectively through community-based services and preventive care.
In both cases, the underlying causes often lie elsewhere in the system. Reducing pressure on prisons may depend as much on improving educational opportunities, transport links and employment prospects as on expanding prison capacity. Similarly, pressure on the NHS is closely linked to public health, housing and lifestyle factors.
The Burnham administration has announced plans in several of these areas. However, the effects of policy changes are difficult to predict and may take years to emerge.
Assessing their impact on future public finances is therefore challenging, including for the OBR.
For that reason, it is unfortunate that much of the debate around the Budget is likely to focus on fiscal headroom. While it has an important technical role, it is only one measure. The more important questions concern how the government can address the deep-rooted economic and social challenges shaping the UK's future prosperity and public finances. With Brexit continuing to constrain the UK’s economic prospects, closer relations with the EU and a renewed focus on long-term structural challenges deserve far greater attention.
About the author: Christopher Martin is Professor of Economics in the Department of Economics at the University of Bath and a member of the Macroeconomics and Finance Research Group. His research focuses on monetary policy, labour markets and inflation.
All articles posted on this blog give the views of the author(s), and not the position of the IPR, nor of the University of Bath.
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