Rising debt and spending demands squeeze Britain’s finances

The UK’s public debt burden has surged faster than that of any other big advanced economy since the eve of the Covid-19 pandemic, helping drive up interest payments and limiting the country’s capacity to spend more on defence and care for an ageing population.

Chancellor Rachel Reeves will on Wednesday try to grip the public finances after higher interest rates and weaker growth blew her fiscal plans off course just five months after Labour’s first Budget since taking office. 

But her Spring Statement spending cuts would provide only a temporary fix to deeper budgetary challenges associated with rising age-related outlays and demands for a rearmament drive, economists warned.

UK gross government debt rose from 85.7 per cent of GDP in 2019 to 101.8 per cent in 2024, an increase of more than 16 percentage points, the largest rise across 40 advanced economies bar Singapore, according to IMF data.

The rise reflects Britain’s stagnant economic growth and the legacy of costly government responses to the pandemic and higher energy costs. Economists said Reeves would struggle to meet rising demands on public services, while curbing borrowing and avoiding tax rises for long.

“The underlying fiscal position for the UK is not yet on a stable footing,” said Ben Nabarro, UK economist at Citi. “Further bad news may lie ahead in the autumn.”  

Reeves is expected to unveil a fiscal repair job approaching £15bn via cuts to departmental spending and welfare in her Spring Statement, as she responds to updated forecasts from the Office for Budget Responsibility.

But even as she vows to stick with manifesto pledges to spurn personal tax increases, Reeves faces Labour backbench demands for investment in public services alongside US-led pressure for a step-change in European defence spending.

At the same time, the legacy of the sharp rise in the debt burden since 2019, coupled by the “debacle” of former Conservative prime minister Liz Truss’s tax-cutting “mini” Budget, had left financial markets “jittery” about further increases in UK government borrowing, warned Stephen Millard of the National Institute for Social and Economic Research.

The UK, like many other European countries, borrowed heavily to support its citizens during the Covid-19 pandemic and to cushion the blow from soaring energy prices following Russia’s full-scale invasion of Ukraine.

Sandra Horsfield, economist at Investec, said higher interest rates and relatively high proportion of index-linked debt compared with many other nations, coupled with slower trend growth than in the US, had “made servicing additional debt more burdensome for the UK than for many of its peers”.

In the current fiscal year, the OBR expects the country to spend about £105bn in interest on debt, well above the £88bn spend for universal credit, the £37.5bn for defence, the £72bn for investment or even the £90bn for education.

The cost of unwinding the Bank of England’s quantitative easing strategy has also weighed heavily on the public finances, as the UK uses an accounting treatment that shows greater upfront costs than in other economies, including the Eurozone and US.

Some countries, such as Ireland, Portugal and Switzerland, saw their debt-to-GDP ratio decline between 2019 and 2024. In Germany, which is planning to dramatically increase borrowing, debt to GDP rose by 4.1 percentage points to 62.7 per cent over that period, leaving it greater scope to increase borrowing than many of its European counterparts. 

Even after recent gains, the UK’s overall government debt-to-GDP ratio still remains lower than in many other countries, such as the US, Italy and France.

Labour’s solution to Britain’s fiscal conundrum is, unsurprisingly, growth. Reeves and Prime Minister Sir Keir Starmer have vowed to pursue pro-growth reforms such as looser planning rules and trimming back business regulation.

But Reeves also hit businesses with the bulk of £40bn a year in extra taxes in her October Budget. GDP growth has yet to pick up since the party took power last July. Meanwhile, borrowing has persistently overshot official forecasts, and the debt-to-GDP ratio is forecast to carry on rising this decade.

“There’s no doubt the fiscal position is dismal,” said Ruth Gregory, economist at the consultancy Capital Economics. “In an environment of lower growth and higher interest rates, it is more difficult to get public debt as a share of GDP falling.”

Demands on the public finances will only grow, economists warn.

“Longer term, the pressures on the public purse from population ageing are clear in the UK,” Horsfield added. “Starting from a substantially higher debt level adds to the challenge.”

Reeves’ announcements in the Spring Statement will be focused on restoring the headroom needed to meet the “stability rule” of paying day-to-day costs with revenues by 2029-2030.

It is a difficult target: the UK has managed to fund day-to-day spending entirely with taxes in only three years this century.

Officials expect Reeves to bring the amount of headroom against that rule back to about the £10bn mark, roughly where it stood in October. 

The chancellor is set to confirm plans to lift defence spending from 2.3 per cent of GDP to 2.5 per cent, but this is widely seen as inadequate given US President Donald Trump’s diminishing commitment to Europe. European leaders have been debating lifting defence spending to as much as 3.5 per cent of GDP or higher in the coming decade.

“We’re now moving into a world in which defence spending is rising as a fraction of national income — and we know that spending on health will definitely rise at a time when the population is ageing,” warned Paul Johnson, director of the Institute for Fiscal Studies. 

“We’ve got low growth, we’ve problems with spending on other parts of the welfare state, social care, and all those sorts of things,” he added. “This puts us in quite a tough position.”