UK borrowing costs up after markets spooked by Reeves’s income tax U-turn

Britain’s borrowing costs have jumped while the pound has dropped after the chancellor’s extraordinary last-minute decision to ditch tax-raising plans in the upcoming budget.

Interest rates on government bonds rose by more than 10 basis points in early trading, putting them on track for their worst day since 2 July, when investors responded to a tearful appearance by Rachel Reeves in the House of Commons chamber. The pound, meanwhile, dropped 0.5% against the dollar.

The markets reacted after government sources confirmed Reeves had dropped plans to raise income taxes to help close a multibillion-pound shortfall in her budget.

The U-turn came despite weeks of warnings to Labour MPs and the wider public that the chancellor might have to break her manifesto pledges on tax to avoid a market meltdown.

Government sources said the decision was taken after seeing improved economic forecasts from the Office of Budget Responsibility, but it also came amid a turbulent week for Downing Street in which the prime minister’s allies have moved to shore up his leadership.

Kathleen Brooks, a research director at the brokerage XTB, said: “Bond market volatility is not what the chancellor wants to see with less than two weeks to go before the budget.

“Essentially, the bond market is warning the chancellor that she cannot merely tax the ‘rich’ to fund her lavish spending pledges. Either she broadens the tax base, or she cuts spending.”

Reeves has been working for weeks on plans to raise income taxes at the budget, despite having promised not to do so before the election.

The chancellor has even invited external experts to brief Labour backbenchers on the difficult decisions they are likely to have to defend.

She told BBC Radio 5 Live on Monday: “It would, of course, be possible to stick with the manifesto commitments, but that would require things like deep cuts in capital spending.”

Sources, however, say Reeves and Keir Starmer decided on Wednesday – the latest possible moment to make major changes to the budget measures – to drop the plans and focus instead on a series of smaller tax rises.

The decision came amid a turbulent week for the prime minister, who has been accused of allowing his allies to brief against the health secretary, Wes Streeting, in an attempt to shore up his own leadership.

In a sign that the government has changed its mind on breaking its manifesto commitments, the culture secretary, Lisa Nandy, told BBC Breakfast on Friday that the chancellor took her promises seriously.

“What I can tell you, as somebody who sits around the cabinet table, who has discussions with Rachel and has known her for a long time, is that she won’t play fast and loose with people’s money,” she said.

“She does take our promises seriously, and she will do everything that she can to make sure that those choices are the fairest possible choices.”

Streeting told LBC, meanwhile: “I’m not in favour of breaking manifesto pledges. I think that trust in politics and politicians is low and it’s part of our responsibility to not only rebuild our economy and rebuild our public services, but to rebuild trust in politics itself.”

Economists warned, however, that increasing a number of smaller taxes rather than the headline rates of income tax carried its own risks.

Ben Zaranko, an associate director at the Institute for Fiscal Studies, posted on X: “Considerable risks with this approach: 1) revenues more uncertain; 2) greater risk of damaging economic impacts; 3) lots of angry interest groups, makes U-turns more likely; 4) viewed less favourably by bond market investors, many of whom were expecting an income tax rise.”