Labour is desperate for hope - the budget will be biggest test yet

Once again, the government's narrative on the economy is shifting. 

After a summer warning of tax rises and cuts to deal with the "dire" inheritance allegedly left by the Tories, Rachel Reeves made a conscious "pivot" in her conference speech last month to something more optimistic.

For the first time in Liverpool, there was a hint of more money - a chancellor making clear she understood the importance of investment to get Britain growing once more.

There was further optimism after the government appeared to be deliberately stoking speculation about their fiscal rules - which determine how much debt can be borrowed to finance government spending - and rampant suggestions the definition of debt might change.

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All this means that Cabinet ministers entered their spending review discussions with Treasury chief secretary Darren Jones 10 days ago hoping some sunny uplands would be in view.

But for most, they were not.

'We're going to be digging a hole'

"The briefing doesn't match the reality", groaned one cabinet minister after discussions this week. "It's pain this year, and pain next year," they added glumly.

"We're simply going to be digging a hole which we end up filling in later in the year."

Yes, a little more money for big investment projects in time. But very tricky this year and next running government departments day to day.

And now the mood music coming out of the Treasury is once again more gloomy.

On Thursday the Institute for Fiscal Studies warned that Ms Reeves will need to raise taxes in this month's budget by about £25bn to honour Labour's pledge not to return Britain to austerity.

This is twice as much as George Osborne in 2010, and could even mean increasing employer national insurance contributions - previously branded by Tories a "jobs tax" in election campaigns to deadly effect, along with a slew of other taxes.

Labour only promised in their manifesto to protect the employee part of National Insurance contributions.

However, Sky News has learnt that officials are starting to conclude the situation may yet be even worse than doom-laden report by the IFS suggests - depending on final forecasts, Ms Reeves is likely to have to plug a gap even bigger than the £25bn.

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For a Labour Party desperate for hope, this is a bitter pill to swallow.

Sky News understands that there are three elements driving the need to find cash ahead of the 30 October budget:

• The first remains the problems that stem from the inheritance and initial public sector pay decisions - the £22bn black hole announced back in July, a figure which grows over the subsequent years. Although the cost of some items in the black hole may have shrunk, this remains an ongoing issue and controversially the government may have to resort to borrowing to fill some of it this year.

• The second pressure is a desire by Ms Reeves to find cash to increase department budgets by more than the 1% left behind by her Tory predecessor Jeremy Hunt. Sky News understands she has already begun hinting at this in public, talking about the pressures on public services, and already stated publicly that her priority is the NHS. She must deliver on such talk. However, many departments appear destined to be disappointed even by a small top-up above the 1% increase in day-to-day spending since they must also find big public sector pay increases from existing budgets, meaning everywhere else must get squeezed. People will still not be happy.

• Third is to deliver manifesto commitments, including funding those parts of the "first steps" of Sir Keir Starmer's five missions on health and education. There is just over £9bn of spending in Labour's manifesto, and some departments have been warning they will be impossible to fulfil judging by the current state of the negotiations.

So where will the money come from? There is a "live" discussion in the government about welfare spending, but it already has an issue: Mr Hunt's last budget had promised (and took the money for) a series of welfare changes which have not been legislated for yet and must now be put through parliament - or risk having to find billions elsewhere.

As the winter fuel change and two-child benefit cap row demonstrate, this is the hardest area for Labour to change without a backlash internally.

Then there is tax.

One government source watching from afar described the discovery in recent weeks by Labour ministers that key manifesto promises on tax - on "non-doms" and private equity deals - were now not forecast to deliver the money previously promised as a "big thing" inside government.

Measures on non-doms and a clampdown on "carried interest" on private equity deals are still expected in some form, but Ms Reeves wants a solution that maximises tax income, meaning she will be alert to threats of wealthy businessmen taking their business elsewhere.

Another popular Labour target is capital gains tax (CGT), and the chancellor is considering several options. However, only small raises in CGT are likely to generate cash for the exchequer, meaning bigger rises in this tax are unlikely. The treasury is thought to agree with warnings issued by the IFS about raising rates too far.

Meanwhile, pension funds and investment funds - the star of Monday's investment summit - are issuing major warnings not to tax pension contributions via the national insurance system.

This could reduce workers' long-term savings and squeeze the amount funds can invest, at a time when private sector involvement is key to improving public services according to ministers.

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Some big decisions have already been deferred to a Spring spending review.

A plan for social care will not be announced at this budget, and funding for such is more likely to come in the first half of next year.

Meanwhile, funding for an industrial strategy and plan for growth is likely to be the centrepiece when the government works out how it will spend its budgets from 2026 onwards.

However, by budget day itself, the government will want to give Labour MPs more hope.

Ms Reeves will not want to give too gloomy a statement, even though there are some who struggle to see how the sums will add up by budget day - without ensuring hope.

The chancellor has been clear she wants to show she is delivering on education with more teachers - while Morgan McSweeney has put making progress with the NHS top of his list of priorities to help with the next election. Expect money for both, in an otherwise very tricky moment.

This is the biggest test of the government to date.

(c) Sky News 2024: Labour is desperate for hope - the budget will be biggest test yet