As Rachel Reeves prepares to deliver her first budget as chancellor, she needs to find more than £40bn to plug the black hole in the country’s finances. Hannah Fearn asks the experts what this might mean for your tax bill – and whether her plan is likely to work

How much does the government take in taxes each year?

Last year, the UK government raised approximately £1.1trn from taxation. This makes up around 40% of GDP, the official measurement of the size of the economy – the highest level since the early 1980s, according to parliament’s own calculations.

Most tax comes through three main sources: VAT, income tax and National Insurance contributions (NICs). Together they raised £626bn in 2023-24. But while everyone pays VAT on their purchases, most of the income tax take is paid by higher earners. The 10 per cent biggest earners paid more than 60 per cent of all income tax last year. For lower income households, a higher share of their personal wealth is paid in indirect taxes, which include VAT, fuel duty and charges on high-tax products such as alcohol, tobacco and sugary drinks.

What does the government spend our taxes on?

The government spends tax income on public services and investment in infrastructure and other major projects.

According to the Office for Budget Responsibility (OBR), the three biggest areas of government tax spending are on health and the NHS (amounting to around £179.6bn), education (£84.9bn) and defence (£32.8bn). Other large government costs include benefits, both for old age pensioners and for working-age people needing support, and capital investment in roads, buildings and other infrastructure, plus investing in important businesses and industries.

The government also spends some of the money on servicing the interest on its debts.

Will there be any tax cuts in the budget?

Not likely, warn experts; this is a difficult time for the country economically and the chancellor is expected to raise many taxes in order to plug a £40bn (or even bigger) “black hole” in the nation’s public finances.

But there may be some surprises. According to Isaac Delestre, a tax research economist at the Institute for Fiscal Studies (IFS), current projections by the OBR anticipate that Reeves will include a rise in fuel duty, ending the 5p cut that was introduced by the previous government. “If that doesn’t happen, that will be scored as a tax cut,” he says.

Meanwhile, wealth manager Matthew Parden, chief executive of Marygold & Co, says he “wouldn’t be surprised” if the tax-free personal allowance was raised – even though most economists aren’t expecting that due to the huge sums Reeves is trying to find.

“For pensioners, it’s important that the tax-free personal allowance should always be higher than the state pension, which is paid gross, to ensure that pensioners aren’t burdened with a tax return if they have no other income,” he says. “Raising it by more than inflation might soften the blow to pensioners losing the winter fuel allowance for pensioners with a small additional source of income like a private pension. For working people an increase in the personal tax-free allowance is clearly welcome, even if it might be clawed back through other tax measures.”

So who will feel the pain? And what tax rises should we prepare for?

In the election manifesto earlier this year, Labour promised not to increase three key taxes: income tax, VAT and NICs for “working people”. On the third, she’s already expected to perform a semi U-turn on budget day, with rises in the employer contribution paid by businesses – a tax on staff wages.

Dr Mary-Ann Stephenson, director of the Women’s Budget Group, thinks this might be a wise calculation, despite concerns from business leaders and some economists that it could hit employment figures. “We don’t really know how much impact it will have on employment patterns,” she says. “We saw a similar thing around the introduction of the minimum wage – an argument that this would lead to a drop in employment – and that didn’t actually happen.”

John Springford, an economist and a visiting fellow at the Institute for Policy Research, says investors should expect see a significant hike in capital gains tax (CGT). “The owners of stocks and shares and other forms of capital are going to see higher tax bills when they sell those assets,” he says, “and for a lot of people that won’t make a huge difference unless they’re sophisticated investors.” But, he warns, it could be an unexpected hit in future years for those with large pension savings in a range of defined benefit or private pension schemes.

“If they’re going to sell – if, as they get older, they want to draw down that income – they may find some of the capital gains they’re expecting won’t quite be so big after all,” he explains.

Delestre believes that the chancellor will be clever enough to link the CGT charge to the interest rate, to prevent the charge becoming a disincentive to invest and levying charges on only the wealthiest. If she doesn’t do this and opts for a single higher rate, he warns, Reeves could “penalise saving more and distort behaviour”.

The other likely change – and possibly the most controversial – is an increase in inheritance tax, including the removal of some of the exemptions that can be used to avoid paying it. Currently only 4 per cent of estates left by the deceased result in an inheritance tax bill – but that percentage is rising every year and is expected to grow rapidly as the Baby Boomer generation, many of whom have acquired significant housing wealth, start to pass away. Changing it now could bring in big money in the next two decades.

‘If you are going to have an inheritance tax an easy place to start would say that it should apply to all assets equally,’ Delestre says – including pensions, which are currently passed on to relatives without taxation. “[Right now] pensions are treated more favourably as a bequest vehicle than they are for providing you with an income in retirement,” he laughs.

On budget day, the winners and losers are usually set out in cash terms – such as whether single people, or pensioners, will be better off than families with young children at home.

As Dr Stephenson points out, the discussion about tax on budget day often focuses on the immediate winners and losers in cash terms. A fairer debate would look at who wins from a higher tax take – such as the users of public services could be bolstered by a stronger exchequer. “If you are losing public services, or they are on their knees, so you’re having to give up your job or suffering from extreme stress, then all of those things are a budget impact too.”

What impact will tax increases have?

According to Springfield, even if Reeves hikes these taxes, the UK’s tax to GDP ratio will still be comparatively low compared to other European nations – including countries such as Germany, Denmark and the Netherlands which are all more productive than the UK.

Nevertheless, he says there will be a change of mood when tax cuts hit. “We’re looking at the overall tax take that the government takes out of the economy rising by about 1 or 1.5 percentage points. That, ultimately, is going to be felt across the economy. You’re going to get a bit less consumption.”

Delestre, meanwhile, thinks the government’s calculation that loading a hike in NI payments onto the employer rather than employee will make it more digestible to voters is likely to be wrong in the long term. Employees will feel the pain, whether that’s through pay freezes or a lack of movement in the job market. “Just because the employer is writing the check you can’t expect the impact of it to fall any differently. In the long term, it is the same people who end up bearing the cost. Whatever you’re saying, it is a tax on people’s wages.”

Why does Labour think tax increases are a good idea?

The government needs to find billions in new income to meet its commitments around rebuilding the NHS, fixing the care system, developing new homes and other promises in terms of improving public services available to citizens. Matthew Parden says the party’s pre-election pledges made it clear that there is a “guiding principle” that middle-income families will not be affected by the choices made in the budget, in order to insulate them from further pain during the cost of living crisis. “The biggest unknown to many of these middle-income households are the damaging effects of inflation and the costs of living, and lifestyle inflation over the years has made it harder to adjust when costs go up.”

It is also making a political choice to hit the wealthiest sections of society first – a move which Dr Stephensome welcomes. “Wealth taxes are a really important part of the mix,” she says. “It’s really unfair that those whose main income is from inherited wealth pay less, proportionately, than a care worker.”

Will Rachel Reeves’ plan work?

Dr Stephenson is unconvinced that enough can be raised without considering changes to income tax or VAT. “I have concerns about the way in which the gov has boxed itself in which limits its room for manoeuvre,” she says. “The scale of investment we need for our infrastructure needs more than that.”

Delestre says the changes expected on Wednesday are broadly positive for the UK tax system, but agrees they will find too little money to meet the chancellor’s ambitious plans for government. “She’s going into her budget with one tied behind her back,” he says.