Chancellor John Healey is facing a £24bn real-terms squeeze on the public purse as higher inflation forces the government to consider tax rises and spending reallocations to meet its policy commitments, according to a warning from the National Institute of Economic and Social Research (Niesr).

Niesr said price growth will peak at 3.8 per cent early next year before gradually returning to the Bank of England’s 2 per cent target in 2029. That path, the think tank said, could reduce the government’s spending plans by nearly 4 per cent by the end of the decade, tightening room for manoeuvre at a time when ministers are trying to balance day-to-day spending with longer-term commitments.

In real terms, Niesr estimated this would amount to a £24bn squeeze on spending.

The researchers said Healey must avoid increasing borrowing and instead raise taxes and reallocate existing spending to fund pledges including support for households facing the cost of living and a rise in defence spending to 3 per cent of GDP by 2030. That makes the inflation outlook important not just for households and the Bank of England, but for the government’s ability to keep to its fiscal plans without reopening broader questions over where any extra money should come from.

Professor Stephen Millard, Niesr’s deputy director, said the government would need to consider wide-ranging tax reforms on property and reliefs, cutting the welfare bill, or breaking a manifesto commitment not to raise income tax.

“There is clearly no scope for really increasing borrowing, so it is about choices,” Millard told reporters. “It’s about do you want to pay for a whole bunch of new things out of higher taxes, or can you make spending cuts elsewhere.”

The latest forecast underscores how higher inflation is eroding the government’s spending plans. However, estimates suggest fiscal headroom has not deteriorated by more than about £3bn over the past three months.

Niesr, which takes a more pessimistic view of the UK economy’s trend growth rate than the Office for Budget Responsibility, said there is now a buffer of £3.4bn, down from just over £7bn in the spring. By contrast, the OBR’s more optimistic forecast published before the Iran war put the headroom at £22.7bn.

David Aikman, Niesr’s director, warned Healey that “treading water is not enough” and urged him to move quickly to reduce public debt, noting that UK borrowing costs are the highest in the G7.

Although Niesr slightly upgraded its growth forecast to 1.1 per cent this year and in 2027, it said growth would still remain below the economy’s expected trend rate of around 1.2 per cent.

“Every major shock this century has ratcheted the debt ratio higher, and none of that increase has been reversed,” Aikman said.

“If we are to rebuild the capacity to absorb the next shock, we will need a determined plan to bring debt down over time.

“It is not hard to imagine where that next shock may come from: from the still-unsettled situation in the Middle East, or from a sharp correction in US equity markets, where valuations rest heavily not just on AI delivering, but on today’s leading firms capturing a large slice of the eventual returns.”

Tax fears mount

Niesr’s higher inflation forecast also raised questions over whether the Bank of England could increase interest rates.

Millard said there was a “case” for raising rates, although he doubted the Bank would tighten monetary policy and expected policymakers to take a more cautious approach.

He said higher rates would provide “insurance against the possibility of further price rises coming” and help keep wage growth pressures subdued.

The think tank’s hawkish inflation outlook is another warning for the Bank’s Monetary Policy Committee, with policymakers having met the inflation target in only about three of the past 10 years.

Inflation averaged about 3.4 per cent in 2025 and 2.5 per cent over the previous two years as the UK economy continued to absorb the energy price shock caused by the war in Ukraine and higher business taxes.

The Bank of England’s Monetary Policy Committee is due to decide on Thursday whether to hold or raise interest rates, alongside new forecasts for inflation and growth.

City analysts expect rates to be left unchanged, though many will be watching closely for updates on price growth and any signals on potential hikes in coming meetings.