Iran War Puts £25bn Hole in Healey's First Budget, IFS Warns

The war between the US-Israel coalition and Iran could force the UK government to find an extra £25bn by 2029-30 just to keep departmental budgets level with inflation, the Institute for Fiscal Studies (IFS) has warned.

The price spike triggered by the conflict poses a major challenge for Chancellor John Healey as he assembles his first Budget, due on 28 October. Higher-than-expected inflation threatens to eat into planned public service spending, leaving Healey with a choice between spending cuts, tax rises, or both, the IFS said.

The Treasury declined to comment on what it called "rumour and speculation".

Speaking ahead of this week's annual International Monetary Fund meeting, Healey acknowledged the pressure. "The consequences of conflict in the Middle East and Europe are hitting countries worldwide, leading to higher prices at the pumps and more expensive mortgages at home," he said. "But Britain and our allies can face up to these challenges together."

The chancellor said his Budget "will build on this approach with fiscal discipline helping to deliver economic resilience" and give people "breathing space".

What does the IFS want Healey to do?

The think tank urged the government to make its spending plans credible rather than proposing unrealistic future cuts to make the Budget add up. It cautioned Healey against announcing any spending measures in the 28 October speech that he has no intention of honouring.

"A 'steady-as-she-goes' Budget is not an option available to the chancellor," said IFS director Helen Miller. "Choosing to stay the course with the inherited tax and spending plans would mean allowing inflation to blow departments' spending plans off course."

"Simply pencilling in implicit cuts that he has no intention of delivering would make the Budget a work of fiction," she added.

The stakes for the government are rising. Ministers face growing pressure to show financial markets a tight grip on the public finances as the cost of borrowing climbs. The US-Israel war against Iran and Russia's invasion of Ukraine have together driven up energy prices worldwide, with those costs passed on to consumers through higher prices on shelves and at the pumps. The conflicts have also pushed up the cost of UK government debt interest payments, adding to the pressure on Healey.

How much fiscal headroom is left?

Like other analysts, the IFS expects recent turbulence on bond markets and higher inflation to add around £10bn to forecasts for the government's borrowing costs in 2029-30.

Despite that, the think tank still expects the government to meet its self-imposed fiscal rules: borrowing only for investment projects by the financial year 2029-30, and reducing debt as a percentage of GDP. Inflation pushes up tax revenues, which helps the arithmetic.

But the margin is shrinking. The IFS expects the rules to be met with a buffer, or "headroom", of around £20bn. That compares with the £24bn buffer the Office for Budget Responsibility (OBR) predicted at the time of the Spring Statement. Recent market indications suggest investors would tolerate that degree of reduced headroom.

The IFS also expects any "breathing space" support for households to be temporary and limited in scale.

Why the forecasts could be wrong

The think tank warned that in such a volatile environment its forecasts are exceptionally uncertain. The official OBR forecast, on which the chancellor relies when making his plans, may reach a very different conclusion.

The numbers are stark on the spending side. The IFS reckons that maintaining departments' budgets in the face of higher inflation may require an extra £25bn in 2029-30. That figure excludes any ambition to raise defence spending. Finding such a sum would point to significant tax rises.

The chancellor does not have to address spending totals in this Budget. He may choose to defer those decisions until future fiscal events, such as next year's Spring Statement or Spending Review, by which point the economic outlook could look very different.

But delaying carries its own risk. The IFS warned that the spending plans inherited from the previous chancellor, Rachel Reeves, would leave some departments' budgets falling behind inflation within a few years. Failing to address that, the think tank said, would cast doubt on the credibility of the government's plans.

Precedent offers a cautionary note. Previous chancellors have relied on a similar strategy of pencilling in unrealistic future spending plans to meet the fiscal rules on the day, only to change the plans later. Healey's choice on 28 October, between honest arithmetic and that inherited fiction, will signal how he intends to govern Britain's finances through a period of war-driven inflation.