Chancellor given Budget warning as Iran war borrowing costs slash headroom by billions

A new report indicates Chancellor John Healey will come under pressure to raise taxes or cut spending at next month’s Budget, after soaring borrowing costs from the Iran war and weaker growth wiped almost £12 billion off the Government’s fiscal headroom.

KPMG's latest economic outlook suggests Mr Healey might be left with around £12 billion in fiscal headroom this autumn, down from £23.6 billion projected in the spring forecast.

The report noted that higher borrowing costs on UK debt following the Middle East conflict have cut about £9 billion from headroom, with slow growth and expected downgrades by the Office for Budget Responsibility (OBR) likely to reduce it by another £2 billion.

KPMG said: "The Chancellor will have limited scope to provide significant support for growth or the cost of living when the Budget is delivered next month, as higher borrowing costs and weaker growth have reduced the Government’s fiscal headroom.

"Restoring the previous level of headroom could require tax rises or spending reductions. With the Government committed to not increasing taxes on working people, the Chancellor may need to consider other tax measures."

Long-term borrowing costs have mounted amid a gilt sell-off, driven by inflation fears linked to the Iran war and growing expectations that interest rates will rise before year end.

These factors combine to leave Mr Healey with "limited room for manoeuvre" for his inaugural Budget on October 28, KPMG said.

The group predicts UK interest rates will likely increase from 3.75% to 4% in November, before retreating next summer as the impact of energy prices on inflation wanes.

Inflation, which stood at 3.1% in August, is projected to reach around 3.5% this autumn and peak at roughly 4% in the first quarter of next year.

KPMG forecasts overall growth of 1.3% in 2026, with activity slowing in the final six months as inflation impacts household spending.

Growth is expected to edge up to 1.4% next year, the report added.

The Autumn Budget will take place on 28 October, and will be Mr Healey’s first since being appointed Chancellor by Andy Burnham in July.