The Office for Budget Responsibility (OBR)’s optimistic economic growth and productivity forecasts could force Chancellor Rachel Reeves into difficult decisions regarding spending cuts or tax increases, economists warn. City experts suggest the OBR may have overestimated the economy’s strength, potentially leading to downward revisions in its March forecast update. This comes as the Conservative Party estimates lower growth could create a £10 billion shortfall in tax revenue.
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Downgrades to the economic outlook pose a significant challenge to the Chancellor’s budget, already strained by rising borrowing costs in financial markets. Spending cuts or tax hikes accompanying the Spring Statement appear increasingly probable. In October, the OBR projected 2% economic growth for this year. However, recent private sector projections compiled by the Treasury suggest growth of only half that rate. This follows a period of sustained economic weakness since the Labour Party came to power last July, with the economy growing by a mere 0.1% in the final quarter of last year and stagnating in the preceding three months.
City Economists Predict Continued Economic Weakness
City economists anticipate continued weakness into 2026, forecasting 1.4% growth, slightly exceeding the OBR’s 1.8% projection. Michael Saunders, a former Bank of England Monetary Policy Committee member, criticizes the OBR for consistently overly optimistic forecasts over the past decade, suggesting their latest projections prioritize hope over experience. Citi economist Benjamin Nabarro also raised concerns about the OBR’s “very, very high” productivity growth forecasts, significantly deviating from the consensus within the UK macroeconomic community.
These forecasts threaten Chancellor Reeves’s carefully balanced financial plans. The October budget left only £9.9 billion in headroom to meet fiscal targets, a margin vulnerable to erosion by lower growth and higher interest rates. The Conservatives warn that if the OBR aligns its growth forecasts with the Bank of England’s recently downgraded projections, a £10 billion shortfall in tax receipts could wipe out the Chancellor’s headroom.
The Bank of England halved its growth forecast this month, predicting 0.75% expansion in 2025, down from 1.5% in November. While acknowledging slower growth in the previous year, the Bank slightly increased its 2026 and 2027 forecasts, anticipating a rebound from this year’s poor performance. Shadow Chancellor Mel Stride argues that the resulting GDP shortfall compared to the OBR’s October prediction will create a significant revenue gap for Chancellor Reeves. Stride criticizes Labour’s economic management and warns of potential borrowing increases if lower growth impacts tax revenues.
Weak Productivity Growth Poses Significant Threat
A significant concern arises from weak productivity growth. The OBR projects output per hour worked, a crucial measure of productivity, to grow by 0.9% this year and 1.1% in 2026. However, private sector forecasts anticipate only 0.6% and 0.9% growth, respectively. Sustained weak productivity growth since the financial crisis continues to hinder the UK economy.
According to Oxford Economics, every 0.1 percentage point downgrade to productivity costs the Chancellor approximately £7 billion. If realized, the private sector forecasts could create a £20 billion budgetary shortfall this year. This would force the Chancellor to consider either tax increases or spending cuts to balance public finances and adhere to fiscal rules.
Saunders highlights that rising interest rates have already eroded over half of the Chancellor’s headroom. A downward revision of the OBR’s potential growth forecast for 2025-2029 to align with the consensus could necessitate roughly £20 billion in fiscal tightening to maintain the current headroom. He criticizes the OBR’s lack of clear justification for its productivity forecast, suggesting it relies on hopeful assumptions rather than a structural analysis of influencing factors.
Potential Offsetting Factors: Inflation and Pay Growth
Despite these challenges, Chancellor Reeves might benefit from higher inflation and pay growth. Inflation has risen to 3%, with the Bank of England anticipating a potential increase to 3.75% later this year. Private sector forecasts expect inflation to exceed the OBR’s projections for this year and next, potentially generating higher VAT receipts.
City economists also predict higher pay growth than the OBR, with earnings potentially rising by 3.5% this year and 3.1% next, significantly surpassing the official forecasts of 2.3% and 2.1%, respectively. These pay increases could push more workers into higher tax brackets due to frozen income tax thresholds, potentially offsetting some of the negative impact of higher borrowing costs and weaker productivity. Saunders estimates this “tax drag” could generate an additional £9 billion in headroom for the Chancellor.
The Treasury received the OBR’s latest tax and spending estimates on Wednesday. A Treasury spokesman reaffirmed the government’s commitment to sound public finances and economic stability, emphasizing the non-negotiable nature of its fiscal rules and declining to comment further while the OBR prepares its official forecast.
