Britain Is Funding Permanent Spending With A Cyclical Bank Tax

On Wednesday 28 October the Chancellor, John Healey, is widely expected to raise the bank corporation tax surcharge from 3 per cent to 8 per cent, reversing the cut made in April 2023 and taking the combined headline rate on bank profits from roughly 28 per cent to roughly 33 per cent. The argument in the press has been about fairness: whether lenders who did well out of high rates owe the public something back. That argument is reasonable, and it is not the one that matters.

The problem with this measure is not that it is unjust. It is that it is poor accounting. The Treasury is proposing to fund permanent spending commitments with the single most cyclical revenue line available to it, and to book that revenue at the top of the credit cycle rather than the middle of it. Our view is that the surcharge rise will raise materially less than the roughly £2.25bn a year the TUC has estimated, that the Office for Budget Responsibility will nonetheless score something close to the full amount, and that the gilt market will be right not to treat the package as consolidation.

The hole and the plug have the same parent

Start with where the gap came from. The OBR's March 2026 forecast left the Chancellor around £23.6bn of headroom against the current budget surplus target for 2029-30. Estimates of what survives now cluster around £10bn to £15bn, Aberdeen Investments among them. Most of the erosion is the cost of money. The OBR's own rule of thumb is that each sustained one percentage point rise in yields adds about £8.4bn to borrowing by 2030, and the Institute for Fiscal Studies has put the combined effect of higher rates and inflation at roughly £11bn of extra net debt interest by 2029-30.

The ten-year gilt yielded 5.44 per cent after this week's labour market data, and the twenty and thirty-year parts of the curve are approaching 6 per cent. Britain has the highest government borrowing costs in the G7.

Now look at where the money is coming from. Bank profits are high for the same reason the debt interest bill is high: Bank Rate has sat at 3.75 per cent all year and deposit pass-through has lagged it. The surcharge is, in substance, a tax on the level of Bank Rate. The hole and the plug are two expressions of one variable.

That sounds like a hedge, and through the rate channel it is one. The trouble is the second channel. Rates are high in 2026 not because Britain is booming but because energy is expensive: Brent settled near $116.72 a barrel on 23 October, briefly above $117 and the highest since early May, on the Iran conflict and the threat to traffic through the Strait of Hormuz. September CPI was 3.5 per cent, the highest in almost a year, driven by petrol. Core inflation was 2.8 per cent. Tight money held against a supply shock does not produce fat bank margins indefinitely. It produces loan losses.

Banks are not earning this much, they are losing this little

This is the checkable part of the case, and the reason we are confident rather than merely sceptical.

Barclays reported third-quarter figures on 22 October. Pre-tax profit rose 12 per cent to £2.3bn. The interesting line was not the profit but the provision: credit impairment charges fell 20 per cent to £503m from £632m a year earlier, and the quarterly loan loss rate dropped to 43 basis points from 57. The bank's own through-the-cycle guidance range is 50 to 60 basis points.

Read that again. A UK lender is currently provisioning below the bottom of the range it tells investors to expect across a full cycle. That is the definition of a cyclical peak in the taxable base. That is no criticism of the bank, which is reporting what its book is doing. It is a problem for anyone building a five-year revenue forecast on it.

Normalising a 43 basis point loss rate to the middle of a 50 to 60 basis point range is not a recession scenario. It is the banks' own definition of ordinary. And it comes straight out of pre-tax profit, the base the surcharge is levied on.

The leading edge is already visible elsewhere. Lloyds' first-half 2026 impairment charge rose to £617m from £442m, which the bank linked to a weaker economic outlook. Lloyds reports third-quarter figures on 29 October and NatWest on 30 October, which is to say the Chancellor will tax this base on Wednesday and the market will find out what it is actually doing on Thursday and Friday.

A lending cut is a tightening nobody is counting

There is a second cost, and it lands on the other side of Threadneedle Street.

UK Finance has written to the Chancellor arguing that an 8 per cent surcharge would reduce lending by about £10bn by 2029. The industry has separately put the hit to output at around £6bn over five years. Discount those numbers as the special pleading they partly are, and halve them. What remains is still a reduction in the supply of credit, delivered by fiscal decision, six days before the Monetary Policy Committee meets on 5 November.

The Committee held Bank Rate at 3.75 per cent in September on a 6-3 vote, with the three dissenters wanting 4 per cent, and is widely expected to hike on 5 November. It will do so having priced the tightening it controls and not the tightening the Chancellor delivered the week before. A surcharge on bank profits reduces retained capital, and retained capital is what supports balance sheet growth. That is a credit condition, not a tax detail.

Britain is therefore about to tighten three times in eight days: fiscal policy on the 28th, bank capital on the 28th, and Bank Rate on the 5th. Only one of those will be recorded as monetary policy.

Why the long end will not pay for this

A Budget which raises real revenue, avoids borrowing more and leaves the fiscal rules intact should, conventionally, be rewarded with lower gilt yields. We do not think the long end will deliver much of that reward, and the reason is specific rather than atmospheric.

Long gilt investors are not primarily worried about this year's deficit, but about whether the UK's revenue base can carry its debt stock through a cycle. A measure that raises its yield when conditions are good and surrenders it when conditions are bad does nothing for that question. It improves the 2029-30 line in a spreadsheet without improving the covenant.

The supply backdrop makes this more pointed, not less. In September the Bank set out a plan to run its monetary policy gilt holdings to zero, with sales of £20bn a year alongside maturities, an average annual reduction of about £46bn against £70bn over the preceding twelve months. It paused all gilt sales until April 2027 and will permanently retain £120bn of gilts maturing in 2049 and beyond. The stock stood at £521.8bn on 30 June 2026. The Bank has, in effect, stepped back from the long end. Whoever replaces it will ask harder questions about revenue quality than the OBR's scorecard does.

The strongest case against us

We should state it properly, because it is not weak.

• The sums are small. Goldman Sachs has estimated the profit impact of an 8 per cent surcharge at 2 to 3 per cent for Barclays and 6 to 7 per cent for Lloyds and NatWest. Against capital ratios in the mid-teens, that is a rounding error, not a constraint on lending.
• Asset quality is genuinely good. A 43 basis point loss rate may reflect a structurally better-underwritten loan book than the pre-2008 comparison embedded in through-the-cycle guidance. If so, the base is not peaking at all.
• All corporation tax is cyclical. Singling out the bank surcharge for this criticism, when VAT and income tax also fall in downturns, is special treatment.
• It may not happen as reported. Hargreaves Lansdown has suggested a two point rise to 5 per cent is likelier than the full reversal to 8. Precedent supports caution: bank shares sold off ahead of the November 2025 Budget on similar speculation and no targeted bank measure arrived.

The third of those is the best one, and our answer is a matter of degree. Bank profits are not merely cyclical; they are leveraged to the cycle twice over, through margin and through provisions, and they are being taxed at a sector-specific rate precisely when both legs are favourable. VAT does not work that way.

What would change our mind

This is a falsifiable claim, so here is the test.

If Lloyds and NatWest report on 29 and 30 October with loan loss rates inside or below their own through-the-cycle ranges, and still do so in twelve months' time with Bank Rate at 4 per cent or higher and Brent back under $90, then the base is structural rather than cyclical and we are wrong. If surcharge receipts hold up through a period of rising impairments, we are wrong. And if the thirty-year gilt rallies durably through the Budget on the strength of the package rather than on a global move in rates, then the market disagrees with us about revenue quality and we should defer to it.

What we do not accept is the framing that this is a cheap £2bn. It is the most expensive kind of revenue there is: the kind that is there when you do not need it.