UK budget options shrink as borrowing costs rise

Prime Minister Andy Burnham’s new government will present its first budget on October 28, 2026, with limited capacity to ease pressure on households and raise defence spending. Rising inflation and borrowing costs have increased the government’s debt burden and narrowed its room for manoeuvre at a time when it has pledged to support living standards and meet NATO commitments under a funded defence plan. Finance minister John Healey intends to keep day-to-day spending in line with tax receipts, in line with existing fiscal rules, and has signalled that credibility and fully costed measures will take priority over large giveaways.

Government debt is around 94% of GDP, constraining options for new unfunded commitments. Public sector borrowing reached £97.8 billion in the year to September, which is 4.3% lower than the same period a year earlier but 6.5% above the level expected by the Office for Budget Responsibility in its March forecasts. Against this backdrop, the budget is expected to centre on smaller, near-term steps to alleviate pressure on household bills rather than broad-based tax cuts or major spending expansions.

Higher interest rates and market yields are weighing heavily on the UK’s fiscal position. As of 0900 GMT on October 26, Britain’s 10-year government bond yield traded at 5.3588%, slightly below its level at the close on October 23 but still at historically elevated territory. Government bond yields in many advanced economies have reached multi-decade highs as global inflation remains stubborn, driven in part by higher energy prices linked to conflicts in the Middle East and Ukraine.

The UK government’s fiscal headroom under its own borrowing rules was previously put at £23.6 billion and is expected to be reduced as higher borrowing costs lift debt-interest payments. The buffer has fallen to about £11.3 billion, largely because of higher borrowing costs and the economic fallout from the Iran conflict. A Reuters survey suggests rebuilding the buffer to around £15–16 billion could help reassure bond investors about the sustainability of the UK’s public finances.

Within these constraints, the government is considering targeted relief to offset rising living costs. Measures in focus include energy subsidies for lower-income households, relief on electricity bills and the possible extension of the existing cut to fuel duty. Burnham has already offered a tax cut on electricity bills, and the upcoming budget is expected to contain further efforts to reduce what Healey has described as “pointless paperwork” in order to lower business costs.

On the revenue side, Healey is expected to rely on a windfall tax on bank profits as a key tool to fund support measures. Oil and gas companies operating in the UK already face a windfall levy on high profits. There has been speculation about extending the mansion tax to properties valued above £1.5 million, down from £2 million currently, as a way to raise additional funds while avoiding increases in income and capital gains tax that have been ruled out.

The Office for Budget Responsibility will publish updated projections for growth, inflation and borrowing alongside the budget, which will be closely watched by investors. Previous official data showed that borrowing has overshot the OBR’s earlier expectations, and higher inflation and interest rates risk further pressure on the outlook even if the government is cautious on spending. The International Monetary Fund has recently projected that the UK economy will grow faster than previously expected this year, before slowing somewhat in 2027.

Chancellor Healey has sought to lower expectations by signalling a relatively uneventful budget, and analysts expect some larger decisions on areas such as housebuilding, defence and public services to be deferred toward 2027. At the same time, the UK government plans to issue debt to provide £20.4 billion of extra support to the National Wealth Fund and the British Business Bank, adding to gross financing needs. With markets already anticipating a possible Bank of England interest rate increase next month, partly due to higher inflation, investors will be alert to whether the budget and OBR forecasts ease or reinforce upward pressure on gilt yields.