U.K. Unveils Biggest Tax Increases and Spending Cuts in a Decade to Shore Up Finances

The measures mark a second major shift in U.K. economic policy in just a matter of months, after previous British Prime Minister Liz Truss spooked financial markets by pledging to jump start growth with tax cuts funded by more borrowing. Her successor Rishi Sunak is now taking economic policy in the other direction, trying to convince investors the U.K. is serious about eventually taming rising government debt. His challenge will be to regain market confidence without causing major damage to an economy widely expected to enter a recession. 

Chancellor Jeremy Hunt announced £55 billion, equivalent to around $66 billion, of spending cuts and tax increases over the next five years, an attempt to begin lowering the size of government debt relative to the economy from the fiscal year ending March 2028. Among the measures, Mr. Hunt said he would raise taxes by freezing the thresholds at which people pay higher rates, pulling thousands of people into the top band of tax as their pay is boosted by wage rises and inflation. The government will also reduce an energy subsidy to households next spring. It is also increasing a windfall tax on energy company profits. 

“Because of our plans the recession is shallower and inflation is reduced,” Mr. Hunt told the lower house of the U.K. Parliament in presenting the plan. “But it means taking difficult decisions,” he added.

The belt tightening by the U.K. highlights the economic challenges facing some Western nations after a sharp rise in spending during the pandemic to shield their economies from damage, as well as new spending to help protect consumers and businesses from far higher energy prices from the war in Ukraine. Higher energy prices could become a feature of Europe’s economic landscape for years to come, meaning governments must decide how to pay for them, economists say. 

The challenge is particularly acute for the U.K. given it was the first economy challenged by financial markets over its finances, when Ms. Truss’s plans for sweeping tax cuts led to a sharp reaction on markets, causing the pound to sink to a record low and the cost of government debt to soar. 

Across western economies, governments have accompanied very low interest rates with ramped up spending, causing government debts to rise, which could become increasingly expensive as higher inflation pushes central banks to raise interest rates, making government borrowing more expensive going forward. 

While the U.K. level of debt is not particularly high, it is also acting to regain credibility with investors following the reputational damage caused by Ms. Truss’s ill-fated “mini-budget,” which caused the pound to sink to record lows and government borrowing costs shoot up. The government’s popularity cratered as voters feared rapid rises in interest rates to contain the inflationary effects of the tax cuts would see their mortgage costs jump. 

Mr. Hunt, who was appointed by Ms. Truss amid a violent market reaction to her budget plans, has spent weeks warning about what he called “eye-watering” decisions on public spending as he junked the tax cuts. 

“In order to keep the markets happy, the fiscal tightening needs to be bigger than otherwise,” said Paul Dales, chief U.K. economist at Capital Economic, a research company. 

Treasury officials hope that the tax hikes will reduce the need for the Bank of England to raise interest rates much above their current 3% rate, in turn lessening pressure on mortgage holders and businesses. But Mr. Hunt must manage a difficult trade-off: cooling the economy enough to bring inflation down without unnecessarily exacerbating an economic downturn. Some economists worry the government may go too far in trying to reassure markets and cause lasting economic damage. 

The U.K. Office for Budget Responsibility, an independent fiscal watchdog, said that borrowing would halve in the next five years thanks to the measures. The research group, funded by the government, said that the economy would shrink by 1.4% next year before then returning to growth. Inflation will be 7.4% next year, the OBR predicts. 

Government officials hope that once inflation is tamed then they can start cutting taxes in time for an election in 2024. But the outlook is grim. The U.K. economy contracted in the last three months and is already on course for a recession that is due to last around a year, sparked in large part by rising energy costs in the aftermath of the Russian invasion of Ukraine. Some economists say that the U.K. recession could last longer than in many Western countries, due to a combination of lingering productivity problems, a deep worker shortage and the decision to put up trade barriers with the European Union after Brexit. 

With the ruling Conservative Party continuing to lag the opposition Labour Party in the polls, Mr. Sunak must balance fiscal rectitude with ensuring the cuts to public spending don’t crater his party’s chances of re-election. To do that the new prime minister is trying to rebuild the Conservative Party’s long-held reputation as a cautious steward of the economy. That reputation evaporated under Ms. Truss. 

The failure of Ms. Truss’s attempt to cut taxes served as a warning to other governments against stimulating the economy when inflation is already very high. If it is successful, Mr. Hunt’s strategy could chart a path to lower borrowing costs and inflation, but could also backfire, potentially highlighting the perils of closing budget deficits too quickly if it pushes the U.K. economy deeper into recession. 

Many economists doubt the need for an urgent effort to cut government borrowing, warning that it could prove self-defeating if it deepens the economic slowdown that began in the three months through September and which the Bank of England expects to last until the end of next year, and possibly beyond. 

“We don’t think that now is the time for spending cuts or tax rises,” said Stephen Millard, deputy director of the National Institute for Economic and Social Research. 

The U.K. government saw its debts rise sharply relative to the size of the economy during the pandemic years, when it spent hundreds of billions of dollars on helping households and businesses. But so did other governments. According to the International Monetary Fund, its government debts were equivalent to 95.3% of gross domestic product in 2021, compared with 121.8% in the U.S., 112.6% in France and 150.9% in Italy.