Prime Minister Andy Burnham will struggle to deliver "fundamental" cost of living support without raising taxes, economists have warned, after a spike in government bond yields in recent weeks.

Higher-than-expected government borrowing in July has deepened the problems facing the UK's public finances, narrowing the range of extra cost of living measures available to the Prime Minister.

Rising gilt yields and pressure on the state to soften the impact of the energy price shock mean Burnham and Chancellor John Healey may be unable to announce fresh spending packages without resetting existing budgets or raising taxes, several economists told City AM.

Ten-year gilt yields, the benchmark for government borrowing costs, peaked above 5.1 per cent on Tuesday before easing slightly, as concerns intensified that the Iran war could drag on. The Bank of England has warned that continued trade disruption across the Gulf region could force it to raise interest rates in a bid to ease inflationary pressures — a step that would add to the £110bn debt interest bill facing the government. Britain's debt interest costs are particularly exposed to such shifts because a large share of UK gilts are index-linked, meaning their payouts rise in line with inflation.

Matt Swannell of the ITEM Club said current market pricing on bonds would wipe out about £7bn of the £23.6bn fiscal headroom allowed under the fiscal rules — the buffer Chancellors must preserve against their targets for debt and borrowing. While that would not "force additional fiscal tightening", he said, it could "limit Chancellor Healey's room for manoeuvre".

"We think that the government will likely continue to follow its playbook since Andy Burnham became Prime Minister, with a focus on low-cost measures to address the cost of living, such as the announced cap on bus fares and upcoming suspension of VAT on electricity bills," Swannell said.

"Anything more fundamental than this would require other spending cuts or tax rises."

Researchers at the Resolution Foundation, a left-leaning economics think tank, said the fiscal headroom was likely to be smaller still — below £8bn in total — as the effects of the Iran war could yet weigh on output growth.

Burnham and Healey may turn to taxes

Borrowing has climbed more sharply than expected in recent months, in sharp contrast to inflation and growth figures that — like consumer confidence — have come in more favourably than forecasts.

The mismatch leaves Healey in a difficult position ahead of the Budget, the point at which the Office for Budget Responsibility's updated forecasts will provide the official measure of his remaining headroom, with the government under pressure to lift defence spending to three per cent of GDP while also providing support to families struggling with the cost of living.

Analysis by Capital Economics suggested there would be "little scope" to raise borrowing at the Budget later this year. A maximum of about £15bn could be accepted, according to the consultancy, though tax rises are likely.

Deputy chief UK economist Ruth Gregory noted that traders may prove "more tolerant" if extra borrowing were channelled into investment and was cost-effective, although interference with the current fiscal rules could bring back "sensitivity" in the markets. Traders have scrutinised UK fiscal announcements closely since the gilt turmoil that followed the September 2022 mini-budget, when surging yields forced the Bank of England to intervene to stabilise the long-dated bond market.

In a separate note, senior economist Ashley Webb warned that the UK was on track to post a deficit above four per cent of GDP for the seventh year in a row. He attributed the weak performance of recent borrowing data to higher welfare payments, running about £2bn above levels last year.