The article  was first published on OMFIF on  Sep29th, 2025.    

Peter Sedgwick was part of the UK Treasury’s macroeconomic policy team in 1976, Vice President of the European Investment Bank from 2000-06, Chair of 3i Infrastructure PLC from 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19 .

Chancellor of the Exchequer Rachel Reeves will have to tighten fiscal policy significantly in her November budget. She should use the next two months to construct a package that both reduces borrowing and reforms tax and public expenditure. This would be the best way to avoid a crisis in the bond markets that in turn would lead to the government completely losing control of its agenda.

While previous market crises in 1976 and the UK’s exit from the European Exchange Rate Mechanism in 1992 played out primarily in the foreign exchange markets, the risk now is in the bond markets to which so many governments are turning to finance their deficits. As in 1976, there is a sharp divide between the objectives of the government’s supporters and what is necessary to satisfy markets.

Difficult decisions over taxes

Putting fiscal policy on a secure footing for the first time since the pandemic will involve not only government borrowing being on a downward path (and not just in the final year of Labour’s term), but also reducing the government’s large current deficit through which much current spending is financed by borrowing that creates liabilities but no assets. Within public expenditure the urgent need is to curtail the unsustainable growth of pension and benefit expenditure, while taking even more drastic action to reverse the sharp falls in public sector productivity since the pandemic.

The guiding principle for tax policy should be long-term reform rather than looking for quick revenue raisers from the wealthy and companies; such measures often have disappointing yields as well as adverse effects on enterprise. To ensure that borrowing falls while tax reforms are enacted it may be necessary to increase income tax. Any such increase could be structured to protect those with the lowest incomes and be temporary through the use of a sunset clause in the legislation.

The alternative, and more likely outcome following the government’s recent policy reversals, would be a series of opportunistic tax increases on companies, wealthy individuals and capital transactions that could damage the economy and might not satisfy markets.

Since early 2025, UK government borrowing costs have been persistently higher than in G7 and European economies. The yield on UK 10-year government debt is currently over 100 basis points higher than in France, which has a higher debt-to-gross domestic product ratio than the UK, cannot agree a budget and has lost two prime ministers trying to agree one. This can only reflect the bond markets’ heightened unease about the UK.

Echoes of the past?

There have been suggestions that the UK risks a financial crisis as in 1976 when it had to seek an International Monetary Fund loan, the conditions for which included difficult cuts in public expenditure. The 1976 crisis was different because, unlike now, the exchange rate was persistently falling and there were acute concerns about the UK’s external payments position.

The problem then and now is the difficulty in financing the government’s debt at an acceptable price. By mid-1976 the government was struggling to borrow. Underlying the market difficulties were, as now, persistent worries about the government’s ability to control public spending.

In one respect the current position is more favourable because the government no longer markets its debt through the Bank of England’s antiquated tap system. The Debt Management Office achieves a significant proportion of its sales of gilts through successful auctions, though currently at very high yields. However, a substantial proportion of sales are to foreign buyers that do not have to buy sterling assets in the same way as defined benefit pension funds.

A further negative factor is that the Bank of England will be running down its gilt holdings, albeit at a slower rate than recently. The yield on gilt sales could rise further if buyers of gilts at home and abroad lack confidence that the government has fiscal policy under control. A further rise in UK yields would widen the differential with other sovereign bonds and have dire consequences for the UK’s exploding debt interest bill.

Unwilling to be unpopular

The main lessons from the market crises in 1976 and with the ERM exit in 1992 is that the government loses control of the agenda and past policy commitments are no longer sacrosanct. Appeals for international help in 1976 and 1992, even at prime ministerial level, had no effect. If in the months ahead markets feel that the government is not doing enough to correct fiscal policy, the risk of a crisis will be greater.

There is little willingness among MPs or the electorate to accept the curbs on spending or tax increases necessary to reduce the fiscal deficit. While budgets for many public services are squeezed, any curbs on spending would have to be concentrated on pensions, benefits and public sector employment following the post-pandemic fall in public sector (not just civil service) productivity.

The reversal of the cuts to winter fuel payments and other benefits have increased concerns that unpopular decisions in the budget might be reversed. To reassure markets the government will need to demonstrate that decisions will stick by early parliamentary votes on the detailed measures. In the absence of further expenditure cuts, any fiscal adjustment would have to be achieved entirely through tax increases.

There will be an intense search for extra tax revenues from the income, wealth and pensions of the rich as well as certain industries, such as banking and gambling, that do not have sufficient political appeal to resist. This piecemeal and opportunistic approach risks not only generating insufficient revenue but further distorting the tax system.

Long-term tax reform needed

As with pensions and benefits, a better approach would be to embark on long-term tax reform even though it might not generate much tax revenue in the first few years. An example would be the long overdue reform of council tax to reflect current property values, which could add some extra higher bands to tax high housing wealth fairly. Any such reforms to the tax, benefit and pension systems would need to avoid vague commitments that could be evaded – such as with past pledges to finance care for the elderly – and be structured in a way that ensured early legislative commitment.

Such overdue reforms would not sufficiently reduce government borrowing in the early years. The best course would be to increase a broad-based tax for a two- or three-year period. Following the damaging rise in employers’ national insurance contributions last year, the tax should not be levied on companies or employment. A rise in VAT – a tax riddled with an illogical set of exemptions in need of reform – would exacerbate the problem of inflation that the Bank of England has not yet brought fully under control.

The least bad option, notwithstanding the unwise manifesto pledge, would be a temporary rise in income tax. It would be possible to shield the very poorest by a selective increase in allowances at the bottom of the income distribution, but the basic approach should be to spread the burden of extra income tax as widely and thinly as possible. The use of a sunset clause of, say, three years would be a signal of the determination to make the increase temporary.

It is always possible for a government to go back on a sunset clause, but it would give government, which tends to act too slowly and cautiously with tax reform, a strong incentive to reform successfully and with urgency. Any adverse effect on activity from the fiscal stabilisation could be offset by cuts in short-term interest rates once the Bank of England has inflation under control.