Rachel Reeves delivered the Labour government's spending review on Wednesday, maintaining a commitment to increase overall day-to-day departmental spending while laying out ambitious plans for housing, defence and transport – and testing the limits of the government’s self-imposed fiscal rules.
Building on the spending envelope set out in March’s Spring Statement, the Chancellor confirmed an average 1.2% real-terms increase in day-to-day departmental spending between 2025/26 and 2028/29. Capital spending will rise faster, at 1.8% per year on average to 2029/30.
The initial reaction of financial markets was calm, with gilts steady and sterling little changed – a sign that investors were largely expecting the headline figures.
Economists, however, were raising questions about how sustainable the underlying assumptions are, and suggesting that tax rises might be required in the autumn Budget or a tweak to the fiscal rules.
Social housing and infrastructure prioritised
The most headline-grabbing announcement came in housing, where Reeves pledged £39 billion for an affordable homes programme, calling it the “biggest cash injection into social and affordable housing for 50 years”, facilitated by reforms to planning laws.
Homes England will also receive part of an additional £10 billion earmarked for financial investments aimed at crowding in private capital and unlocking new development. Shares in housebuilders Vistry Group PLC (LSE:VTY) and Crest Nicholson PLC (LSE:CRST) rose 9% and 5% in morning trading, buoyed by earlier leaks of the housing plans.
Transport funding also featured prominently, with Reeves confirming £15 billion of investment – a figure pre-trailed earlier in the week – that included £4 billion for Transport for London and a fourfold increase in regional local transport grants.
Health, education and defence
The Department of Health and Social Care will absorb the bulk of the increase in spending, with its budget set to grow by 2.8% in real terms over the forecast period. The department will receive £215.6 billion in 2025/26, rising to £247 billion by 2028/29.
Education will see its budget rise from £95 billion this year to £100.9 billion in 2025/26.
The Ministry of Defence will jump from £62.2 billion to £73.5 billion by 2028-29, with Reeves reaffirming Prime Minister Kier Starmer's previous intention to increase defence spending to 2.6% of GDP by 2027, with a longer-term goal of hitting 3.0% in the next parliament.
Defence contractors such as BAE Systems PLC (LSE:BA.), Babcock International PLC (LSE:BAB), QinetiQ Group PLC (LSE:QQ.) and Avon Technologies PLC (LSE:AVON) have gained in recent months due to those well-flagged defence spending plans, including a fleet of new nuclear-powered submarines.
Outside of health and defence, other departmental budgets will see a squeeze. Real-terms day-to-day expenditure in all other departments will fall by 0.1% on average. Departments taking the brunt include:
- Transport: -5.0% per year
- Department for Environment, Food and Rural Affairs: -2.7% per year
- Home Office: -1.7% per year
- Housing, Communities and Local Government: -1.4% per year
Despite the cuts, the Home Office budget will still rise in nominal terms from £20.2 billion to £22.3 billion by 2028/29, with a modest increase in Justice and Science and Innovation spending as well.
Fiscal room narrowing
Economists say the review exposes the narrowing room for manoeuvre under the current fiscal framework.
Elliot Jordan-Doak, economist at Pantheon Macroeconomics, noted that without new OBR forecasts, the credibility of the projections is harder to judge.
"The tight fiscal picture continues to cast doubt on the government’s ability to meet its own spending plans.
"The real question is not if, but how much taxes will need to rise."
The Government has ruled out hikes to the major tax rates, but Jordan-Doak expects smaller fiscal measures – including stealth tax rises and duty increases – could emerge in the October Budget. Larger moves would likely require changing the fiscal rules or breaking manifesto commitments.
Kathleen Brooks, head of research at XTB, said her overall reading was that Reeves was "squeezing day-to-day public spending and is focusing on capital investment".
"Even the NHS’s budget increase is linked to big tech projects rather than day to day spending on the public’s health. Thus, there could be a focus on limiting public sector pay going forward, due to the inflationary impact and the fact that the money is not available," Brooks said.
She noted that Reeves "has a history of U-turns when her policies become unpopular with the public".
One possible consequence of tighter fiscal policy, if economic growth slows, is a shift in monetary policy. “Weaker OBR productivity forecasts in October would increase the pressure for tax hikes,” Jordan-Doak added, “but also raise the chances of additional rate cuts from the Bank of England.”
Oliver Faizallah, head of fixed income research at Charles Stanley, noted that while the spending review was not expected to unveil any new spending, "it did put the spotlight on strained public finances when discussing how existing funds will be allocated".
"Markets remain nervous about the potential for either higher taxes or an increase in borrowing in the future. An increase in taxes may be seen as more ‘market friendly’, but would be politically damaging, while an increase in borrowing (funded through gilt issuance) would put further pressure on already elevated gilt yields."
He noted that gilt yields rose on Wednesday afternoon but this "had nothing to do with the spending review but came on the back of a lower-than-expected CPI print in the US", highlighting the high correlation of UK and US government bonds.