Rachel Reeves may have no choice but to raise income taxes if the UK government is to fill a £40 billion black hole in its finances, according to new warnings from a leading economic thinktank. The National Institute of Economic and Social Research (NIESR) says that unless tax revenues rise sharply, the government faces some extremely tough decisions—and fast.

This comes as a blow to Labour, which promised during its election campaign not to raise personal taxes. But a combination of weaker economic growth and stubbornly high inflation has dragged public finances off track.

The warning is clear: if the government wants to avoid cuts to public services or increased borrowing, raising income tax by 5p on both basic and higher rates might be the only viable option.

So what exactly has gone wrong?

The UK economy isn’t growing as fast as hoped. That means fewer people are earning more, and businesses are not generating the kind of profits the Treasury was banking on. On top of that, inflation has been higher than expected, driving up the cost of everything from public sector wages to welfare spending.

The result is a perfect storm—rising costs for government spending, but falling tax receipts.

According to NIESR’s projections, the government is now on course to face a £40bn shortfall in its budget. That kind of deficit can’t be ignored. If it isn’t plugged, it could hurt the UK’s credit rating, drive up interest on national debt, or lead to cuts to key services.

So how could a 5p rise in income tax help?

Right now, the basic rate of income tax is 20p in the pound, and the higher rate is 40p. NIESR suggests adding five percentage points to each, meaning the rates would go up to 25p and 45p respectively. This would impact most working adults, but especially those in higher earning brackets.

It’s a blunt tool, but one that could generate enough revenue to fill the gap—without touching other major tax levers like National Insurance or VAT, which can hit low earners and small businesses hardest.

But there’s a problem: Labour campaigned on a promise not to raise income tax, National Insurance, or VAT. Breaking that promise so soon after entering office could be politically risky. Yet the economic reality may force a rethink.

The challenge now for Rachel Reeves is how to square this fiscal circle—how to maintain public confidence, protect services, and meet borrowing targets without tearing up manifesto pledges.

One option might be to delay or phase in the increase, giving people time to prepare. Another possibility is to focus the tax rise on higher earners only. But these adjustments might not bring in enough to fully close the £40bn gap.

If Reeves chooses to hold firm and keep tax rates frozen, the alternatives aren’t pleasant. The government may have to scale back spending across departments—something that could lead to cuts in local councils, healthcare, education, or infrastructure investment. These are not the kind of choices any government wants to make, especially in its first year.

It’s also worth noting that a rise in income tax—even one this targeted—could affect consumer behaviour. People might spend less, save more, or delay big purchases, which could further slow the economy.

That in turn creates a feedback loop: lower spending means lower business revenues, which means lower tax receipts. It’s a tricky cycle to break.

Still, some economists argue this is the least bad option. After all, the alternative is more borrowing—and with interest rates still relatively high, that’s not cheap. The UK already spends tens of billions a year just on interest payments. Piling more debt onto the national balance sheet could spook investors and raise long-term borrowing costs even further.

Labour may try to avoid a full-blown tax hike by combining several smaller measures—such as freezing thresholds, introducing new tax bands, or closing loopholes for the very wealthy. These targeted strategies might soften the blow and keep their pledge intact in spirit, if not in letter.

But make no mistake: the message from NIESR is blunt. Without some form of increased taxation, the next budget could be a painful one. Public expectations are high, the fiscal headroom is narrow, and the room for manoeuvre is shrinking by the day.

For now, Rachel Reeves is walking a tightrope—between economic necessity and political credibility. And as the scale of the deficit becomes clearer, the pressure to act will only grow.