Britain Braces for ‘Painful’ Budget Meant to Recharge the Economy

The new Labour Party government said it had inherited a challenging financial position and warned of tax increases and spending cuts when it reveals its budget this week.

As Britain’s Labour Party government prepares to deliver its first budget this week, the message to Britons for the past few months has been a dispiriting warning that they may not like what they hear.

The budget, which will be announced in Parliament on Wednesday, will be “painful,” Prime Minister Keir Starmer said. The Treasury, the department responsible for laying out the government’s tax and spending plans, has repeated a relentless mantra: “Difficult decisions” are coming.

Rachel Reeves, the chancellor of the Exchequer, faces the difficulty of setting out a fiscal plan that adheres to Labour’s campaign promises, even though those promises offer little room to maneuver.

Ms. Reeves has vowed “no return to austerity,” which many have interpreted as avoiding cuts to public spending while also promising not to raise taxes on working people. The government has said it will stick to strict rules to push down debt levels and increase investment in an effort to make Britain the fastest-growing economy in the Group of 7 nations.

“It’s a very, very challenging situation,” said Isabel Stockton, an economist at the Institute for Fiscal Studies, adding that there was pressure to spend more on benefits and public services.

“She’s kind of boxed in on those parameters,” Dr. Stockton said of Ms. Reeves. “And then she’s additionally boxed herself in with the commitments she’s made on tax.”

The British government is not alone in making unpopular choices after deficits across Europe increased because governments spent heavily to support households and businesses through pandemic lockdowns and an energy crisis. High interest rates have also raised the cost of government debt. This month, France announced a round of severe spending cuts and tax increases to head off a financial crunch.

The budget announcement on Wednesday has been imbued with a sense of historic importance. It will be the first one by a Labour government in 14 years and the first delivered by a female chancellor of the Exchequer. But it has also been deemed by analysts as a chance for the Labour Party to set its agenda for the rest of the Parliament and as a make-or-break moment after the government’s turbulent early months, which were rocked by criticism over the acceptance of gifts and the resignation of the prime minister’s chief of staff.

Despite the dour messaging, recent economic news in Britain has been relatively positive. The economy grew faster than expected in the first half of the year, recovering from a recession. Last Tuesday, the International Monetary Fund upgraded its forecast for Britain’s economic growth this year to 1.1 percent, from 0.7 percent three months ago. Inflation has dropped to 1.7 percent, and investors are betting that the Bank of England will have to ramp up the pace of interest rate cuts, easing the pressure on mortgage holders and businesses.

Still, the government has not swayed from its message that it will have to make tough choices to ensure fiscal stability and restore long-term economic growth.

After a surge in spending during the pandemic and a spike in inflation, government debt levels are high and interest payments have ballooned. Many public services, including prisons, courts and social care, are stretched. In her first few weeks as chancellor, Ms. Reeves declared that she had inherited a “hole in the public finances” amounting to 22 billion pounds, or $28 billion, because of overspending by the previous government.

“It’s welcome that the I.M.F. have upgraded our growth forecast for this year, but I know there is more work to do,” Ms. Reeves said in a statement on Tuesday. “That is why the budget next week will be about fixing the foundations to deliver change.”

Ms. Reeves has said she will increase some taxes this week. If she wants to bolster departmental budgets and keep other election manifesto pledges, she’ll need to raise £25 billion in taxes, the Institute for Fiscal Studies estimated, noting that it is common for the first budget of new governments to substantially increase taxes.

But the Labour Party has already ruled out increasing income tax; National Insurance, an employment-based tax; and the value-added tax, a type of sales tax, complicating the calculations. The three taxes made up about 60 percent of the government’s revenue last fiscal year. This year, Ms. Reeves is to increase to capital gains tax and inheritance tax instead.

There is also speculation that the government could raise the employer contributions of National Insurance, which funds state benefits, including pensions. But that would breach the government’s vow not to raise taxes on working people, some analysts have said, because companies are likely to pass the cost on to employees by scaling back wage increases.

Some companies are “scratching their heads a little bit,” said Duncan Edwards, the chief executive of BritishAmerican Business, a trans-Atlantic lobby group. “The language has been about delivering a pro-growth program,” he added, but “the action — or at least the telegraphed action — has been to do things which are likely to discourage growth.”

The government needs to show how the budget would increase economic growth and how it fits with other policies, such as the new industrial strategy, to ensure that Britain is more attractive than its European neighbors as a place to invest, Mr. Edwards said.

Still, there are likely to be some welcome announcements in the budget. For example, the Treasury has already announced more money toward affordable housing projects. And in a break with her predecessor, Ms. Reeves also plans to change fiscal rules to give the government more room to borrow for investment for big projects, most likely by changing which measure of debt the government uses when it calculates debt levels over five years’ time. Ms. Reeves has not confirmed what the new measure will be, but she wrote in The Financial Times on Thursday that the changes would mean that expected declines in public sector investment would not go ahead.

Changing that measure “could make quite a big difference” for investment, said Dr. Stockton, the Institute for Fiscal Studies economist. But the bigger issue with the debt rule is that it can be heavily influenced by small changes to economic forecasts far in the future.

“That’s not going to be solved by targeting a different measure; that would be solved by thinking more carefully about the design of the rule itself,” Dr. Stockton said.

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