Britain’s Budget woes illustrate the threat to Europe’s social contract
Many governments have not come clean with voters about the growing fiscal strains on the welfare state
Delphine Strauss and Sam Fleming in London
© FT montage/ShutterstockAddressing voters after Labour’s landslide election win in July 2024, Rachel Reeves vowed to put an end to “prevarication” and “chaos” and repair the public finances of an economy she claimed had been left in its worst state since the end of the second world war.
When she stands before the House of Commons on Wednesday, the UK’s chancellor of the exchequer will be painfully aware of the gulf between those early promises of decisive action and the subsequent reality.
She will also be asking voters to swallow a bitter pill: tax increases that will still leave public services underfunded, in a sluggish economy where productivity growth remains elusive.
But Britain’s budgetary dilemmas are far from unique.
Across Europe and the rich world, governments are facing brutal fiscal trade-offs as they grapple with the rising costs of ageing populations, new security threats, climate change and higher interest rates.
Electorates have repeatedly shown they are not ready to accept these harsh choices.
Reeves’ own political future is in doubt after the reversal of two key fiscal reforms she backed: a set of welfare cuts that collapsed in the summer after a backbench rebellion and a plan to raise income tax that was heavily trailed in the run-up to the Budget — only to be hurriedly abandoned.
In France, pension reform has been put on hold as the fifth prime minister in less than two years fights to keep a functioning government in place.
Now Germany’s chancellor, Friedrich Merz, also faces a rebellion from the youth wing of his centre-right party, over a pension bill it views as too generous to the boomer generation.
Meanwhile, rising debt burdens are a ticking time bomb in bond markets, as investors grow increasingly sceptical of government promises to cut deficits at an ever-receding future date.
“Looking across advanced economies, the challenge is enormous,” says Sebastian Barnes, an economist at the OECD in Paris.
“It requires major adjustments on the spending and tax side of a sort that has very rarely been seen in the past.”
The IMF has been issuing similarly stark warnings.
In a new analysis this month, it predicts the average European country’s public debt would double in the next 15 years if they failed to take “prompt policy action” — leading to even higher borrowing costs, lower growth and market instability.
“Muddling through”, as many countries have so far, would not be enough, the IMF warned.
Even if governments see through tough reforms of pension systems and labour markets, they will still need to cut spending significantly — and those with higher levels of debt may need to face up to a fundamental rethink of the social contract between the state and citizens.
Health secretary Wes Streeting, Rachel Reeves and Sir Keir Starmer visit a health centre in London. Labour won last year’s general election promising to radically improve public services © Jack Hill/WPA Pool/Getty ImagesGenerous welfare, universal healthcare and free education had been “critical” to economic growth and social cohesion across Europe in the postwar period, the IMF said.
Now, “a discussion on the scope and sustainability of the ‘European model’ seems unavoidable”.
Reeves’ experience leading up to her tax-raising second Budget in many ways encapsulates the political difficulty of even broaching these big debates.
Sir Keir Starmer’s government has this year been forced into retreats over reforms aimed at saving money on pensioners’ heating costs and over cuts to disability benefits.
This month it went on to ditch plans to increase income tax, which would have been a violation of its election manifesto.
In both cases, Number 10 Downing Street backtracked in the face of pressure from Labour MPs who are wary of alienating an electorate that has not been prepared for harsh decisions on public spending and taxation.
Labour’s predicament is hardly surprising, given it campaigned on a platform that married pledges of radically improved public services alongside a vow not to increase the rates of the country’s most important levies — income tax, national insurance, VAT or corporation tax.
Together, these bring in three-quarters of the tax take.
The UK’s income tax U-turn damaged Reeves’ and Starmer’s reputation among investors who were already spooked by Labour’s inability to corral its MPs behind proposals to curb sickness benefits, intended to deliver £5bn a year of savings.
UK gross government debt is forecast to be lower by the end of the decade — at 105.4 per cent of GDP — than in countries including the US, France and Italy.
But the country’s long-term borrowing costs remain the highest in the G7.
The bond market is entering the Budget “on a hair trigger”, says David Aikman, head of the National Institute of Economic and Social Research.
Across the OECD, public debt reached 112 per cent of GDP at the end of 2024, the Paris-based organisation estimates, nearly 40 percentage points higher than on the eve of the global financial crisis in 2007.
Sluggish growth is making it ferociously hard to reverse that trend.
The OECD’s analysis of 34 episodes since the late 1970s shows that when governments have managed to bring down debt ratios, favourable economic conditions have been the key driver.
Spending cuts — now seen as essential — have historically played a smaller role.
The Brussels-based think-tank Bruegel puts the UK in a group of countries, along with the US, France, Slovakia, Poland and Romania, that must increase their primary fiscal balances (excluding interest payments) by more than 5 percentage points of GDP to stabilise their public debt ratios.
For the UK, Bruegel calculates, this would mean running a primary surplus of 1.8 per cent of GDP by 2031 to have a good chance of stabilising debt within 20 years.
A union-led demonstration for better pensions marches through Paris this month. Reforms have been put on hold as the French government seeks to avoid collapse © Ameer Alhalbi/Anadolu/Getty ImagesThese countries’ debt is sustainable “in the sense that the fiscal adjustment required . . . is feasible”, Bruegel judges.
Indeed, some countries such as Greece and Portugal that made similarly painful cuts during the Eurozone crisis are now seeing the benefits.
But it would be a “larger and more protracted” effort than most rich countries have ever had to contemplate — and much harder than in the past, because it will inevitably mean tackling the rising burden of pensions in ageing societies.
“It is just more difficult to cut spending today — it is objectively different from 10 years ago,” says Jeromin Zettelmeyer, Bruegel’s director.
France’s protracted parliamentary chaos makes it most acutely exposed at present to a market sell-off if bond investors lose patience.
Its latest budget bill has been snarled up by thousands of contradictory amendments aiming to raise taxes on the rich.
But Federico Barriga-Salazar, head of the western Europe sovereign team at Fitch Ratings, argues that the only way to put its debt on a sustainable footing is to cut French public spending, which at 57 per cent of GDP was near the highest in the OECD in 2024.
In countries such as France where government revenues already account for more than 50 per cent of GDP, “there is a question as to how much more revenue can be raised”, Barriga-Salazar says, and government promises to boost growth — in the UK and elsewhere — were not yet backed by any substantial reforms that could deliver it.
He and other economists see healthcare as a key area where spending could well overshoot current plans — and savings should be possible.
Is it possible to find savings worth 3 to 4 per cent of GDP in countries such as France, where annual public spending is equivalent to half the economy?
“The answer has to be yes,” says Guntram Wolff, professor at the Solvay Brussels School of Economics and Management.
“We are living in extremely favourable times in the broader historical perspective — the type of benefits that would have to be trimmed are luxury benefits.”
He argues that “the core of the social contract question is the divide between the young and the old” rather than between the super-rich and the rest.
Future generations entering retirement will, he says, have to accept that pensions must be smaller.
Commuters cross Westminster Bridge in London. MPs are wary of alienating an electorate that has not been prepared for harsh decisions on taxation or spending © Mina Kim/ReutersMeanwhile, the IMF points to France, the Netherlands and the UK as countries where richer people could be asked to pay more for healthcare; to Germany and Slovakia as countries where energy subsidies should be cut; and to the Baltic states as ones where taxes will need to rise to match higher expectations for public services and the social security net.
But changes of that kind would break deeply held national taboos.
“That level of openness to changing the social contract is very, very unlikely in western Europe,” Barriga-Salazar says.
Even in Germany, which is using its greater fiscal headroom to embark on a €1tn investment drive to boost defence and infrastructure, problems are emerging.
To keep its debt sustainable, Germany needs to make just as big an adjustment as its peers in other areas, Bruegel’s Zettelmeyer notes.
But for now, the government has resolved this problem “by going quite expansionary for this year and next, and then solemnly swearing to really, really adjust for the rest of their term.
They are planning this rollercoaster for the economy . . . but they don’t know where the [savings] are going to come from,” Zettelmeyer says.
Worse, much of the new borrowing intended for investment is being used for regular spending, including on tax breaks for commuters and higher pensions for non-working mothers, according to a new report by the German Council of Economic Experts.
The result is hardly surprising.
Governments across Europe feel they have little room to tell their own constituents that they have to tighten their belts as they fend off challenges from populists, including on the far right.
“We are not alone in this,” Ben Zaranko, an economist at the Institute for Fiscal Studies, says of the UK.
“Most of the challenges we face are common ones — ageing populations, defence spending, climate.
Lots of other countries are borrowing more than they probably ought to in the aftermath of Covid-19 [and] the energy price increase, and are struggling to bring it down.”
But it is hard to blame the electorate for chafing against higher taxes to fund rising demand for public services when they have been told by politicians that they do not need to pay more, Zaranko adds.
“No one has really made the case.”
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