UK faces ‘very difficult trade-offs’ in budget because of Iran war, say analysts

Andy Burnham has been warned by a leading thinktank of “very difficult trade-offs in the next autumn budget” if the Iran war keeps oil prices and inflation high.The National Institute of Economic and Social Research (NIESR) said the new prime minister faced a “challenging inheritance” and his plans to revamp public services would meet severe pressure from persistently higher prices.With oil prices having briefly gone back above $100 a barrel, and the Strait of Hormuz all but closed since March, the thinktank said it expected inflation to rise to 3.8% over the next seven months, forcing the chancellor, John Healey, to find an extra £24bn by the end of the decade to maintain services and real-terms welfare payments.The thinktank said it had cut its forecast for the chancellor’s spending headroom in the budget from just over £7bn to nearer £3bn. The Office for Budget Responsibility, the government’s independent forecaster, estimated in March that the Treasury had about £22bn of spare capacity above existing spending commitments.Underscoring the cost of the Middle East conflict to the UK, the NIESR said the economy would grow at a slower pace this year and in 2027 as a result of higher energy prices and the spillover effects from uncertainty created by the on-off war.It said a downgrade of growth to 1.1% this year and the same slow pace next year meant the UK would suffer £28bn in lost growth over two years compared with forecasts in January.David Aikman, the institute’s director, said Burnham faced “a challenging inheritance” with spending “eroded by inflation”, coupled with the highest borrowing costs in the G7, new spending demands and cost-of-living pressures.He said there would be a temptation to ease the strain on the public finances and pay for new initiatives by raising the level of borrowing.Aikman said this would be a mistake and only cause further strife in later years, especially when another health or economic shock happened.He added: “New commitments on defence or household support should be funded through taxation or savings elsewhere, not through further borrowing. Rebuilding the capacity to absorb future shocks will require a determined attempt to bring debt down.”Burnham has made several announcements since becoming PM last week, including a pledge to improve adult social care, with an estimated £18.5bn bill for providing an NHS-style system free at the point of use by 2035.He has also singled out for support the 1 million young people classified as not in education, employment or training (Neets), with more extensive mental health services and a revamp of the education system.The NIESR said the government’s total debt, which has reached almost £3tn, or 95% of annual national income, was likely to rise again if the chancellor used borrowing to boost public spending.The institute has proved to be one of the gloomier forecasters, predicting significant economic shocks that proved more muted.Stephen Millard, the head of the thinktank’s macroeconomic forecasting, said the UK economy had proved to be “surprisingly resilient” in the first half of this year “but a slowdown is still to come”.He added: “Even if peace is restored relatively quickly in the Middle East, inflation will still rise and the new chancellor will need to make some difficult decisions with respect to how to fund the latest policy announcements, from cuts to VAT on electricity and business rates for pubs, to the £2 bus fare cap.”Millard said tax changes should be given priority over increases in existing taxes.He said he supported the introduction of a land value tax to replace council tax and stamp duty on home sales. He said the government should also phase out the many exemptions and discounts that affect VAT, including those on energy and children’s clothes.There was further scope to tackle tax avoidance by wealthy individuals and companies, he added.Millard said the latest quarterly economic outlook showed the chancellor would need to cope with a 4% real spending squeeze by the end of the decade – equating to about £24bn in 2023 prices.He said higher and more persistent inflation would create “very difficult trade-offs in the next autumn budget”.The NIESR expects inflation to average 3.1% in 2026, peaking at 3.8% in February 2027 after energy price cap adjustments.It said it would take until early 2029 to fall back to the Bank of England’s 2% target, rather than 2028 as previously forecast.Bank of England officials meet on Thursday. Financial markets expect them to hold interest rates steady before raising them to 4% later in the year.