UK Taxes & The Leaky State
How Debt Interest Drains the UK, And What To Do About It
Every few months, headlines announce that Britain’s interest bill has hit another record. The numbers are vast tens of billions a year, sometimes more than the country spends on schools or the justice system. Yet for most people, it isn’t clear what those sums actually mean. Is the government just “paying itself”? Why does inflation suddenly make the bill balloon? And why, if the Bank of England is part of the state, does it pay commercial banks billions in interest? The news coverage often leaves the public confused, with language like “gilts,” “QE,” and “reserves” left unexplained. But behind the jargon is a simple truth: debt interest is less about funding new things and more about redistributing existing income, sometimes to useful ends, often as pure leakage.
Think of the public finances as a bucket filled by taxes, taxes that you pay. Out of that bucket flow the services people can see and use: schools, hospitals, and infrastructure. However, there are also holes in the bottom of the bucket through which water escapes before it can do anything productive. Those holes are the interest payments. Some of the water drips back into the UK economy through pension funds or insurers. Some gushes out abroad. Some funds are transferred directly into bank accounts at the Bank of England. The leaks do not collapse the bucket; they are part of the design. But when interest rates rise, the holes widen, and more water drains away.
The first leak to picture is the easiest to picture, it’s foreign bondholders. About a third of Britain’s government bonds, called gilts, are owned overseas. When the Treasury pays interest on these gilts, a flow of sterling leaves the UK economy, converted into dollars, euros, or yen. It is not scandalous; it is the reality of borrowing in an open market. But it means that part of the income generated by British taxpayers and workers each year goes abroad and never returns.
The second leak is stranger. During quantitative easing, the Bank of England bought a huge stockpile of gilts. To pay for them, it created electronic deposits for commercial banks, called reserves. By design, these reserves earn interest at the Bank’s policy rate. When rates were near zero, the cost was negligible. With rates higher and reserves still enormous, the payments have become a major subsidy to the banking sector. This is where the “paying ourselves” myth collapses. The money does not loop neatly back to the Exchequer. It goes out the door, day after day, to private banks. Meanwhile, the Bank’s bond portfolio is loss‑making at current yields, and because the Treasury indemnified those losses, taxpayers are on the hook.
The third leak is the inflation‑linked debt. Roughly a quarter of Britain’s bonds are index‑linked, mainly to the old RPI measure. When prices surge, the government’s interest bill surges too. This design helps pension funds hedge promises to retirees, but it also hands windfalls to whoever holds the bonds at the right moment, from hedge funds to foreign investors. A statistical quirk in the RPI can translate directly into billions of extra cost.
Finally, there is the role of sterling as a reserve asset. Foreign central banks and sovereign wealth funds hold gilts as safe stores of value. To maintain that confidence, the UK must offer yields attractive enough to compensate for the risk. In effect, we rent credibility, and the rent shows up in the annual interest bill.
Put together, these channels explain why Britain’s debt interest is high even when nothing new is being built. Debt service is not an investment; it is a distribution. In law, it is also priority number one. Interest on the national debt is a standing charge on the Consolidated Fund: it must be paid before most other spending. The Bank of England’s independence is legislated, and the indemnity on its asset purchases is explicit. Bank and pension regulation funnels institutions into gilts, reinforcing demand but also embedding financial‑sector claims. International commitments and political realities mean that coercive alternatives, such as defaults, forced conversions, and capital controls, would be self‑defeating. The leaks persist not by accident but by design.
For those baffled by the jargon, here is the plain‑English version. Gilts are government IOUs. A coupon is the interest payment on those IOUs. Index‑linked gilts are IOUs where the payments rise with inflation. Reserves are the electronic deposits banks hold at the Bank of England; today, they earn interest. QE (quantitative easing) was a policy where the Bank bought gilts to calm markets and created reserves to pay for them. When you read that “interest on reserves” costs tens of billions, it means that banks are being paid policy‑rate interest on money that exists because of QE. And when you see headlines about “record debt interest,” much of it is these mechanical flows, not the government funding new schools or hospitals, but the government transferring money to creditors.
Why does this matter? Because these flows shape the choices available to any government. High debt interest squeezes the budget, forces trade‑offs, and redistributes income toward banks, pension funds, and foreign investors. Some of that redistribution is socially useful, supporting pensions and financial stability. Much of it is pure leakage, draining national income abroad or into bank profits without adding to output.
Supplementary Data Note: Current Figures and Trends (2025)
These live data points sit alongside the main article. These numbers change frequently, but they show the scale of the UK’s debt interest burden and the channels of financial leakage.
Debt Interest Costs
Central government debt interest (net of APF) is forecast at £111.2 billion in 2025–26, equal to about 8.3% of total spending (OBR).
In June 2025, the government paid £16.4 billion in interest, up £8.4 billion year-on-year, driven largely by index-linked gilts (ONS).
In July 2025, the monthly interest bill was £7.1 billion (ONS).
Bank of England & Reserves
The Bank of England’s Asset Purchase Facility (APF) still held £586.4 billion of gilts as of 20 August 2025.
Commercial bank reserves at the BoE remain high. Recent commentary places the stock near £760 billion, with a “neutral” demand expected closer to £550 billion by late 2026.
Gilt Ownership and Issuance
Around 31% of gilts (£635 billion) were owned by overseas investors as of Q2 2024.
Pension funds and insurers together hold roughly one-third of the stock, with the BoE/APF at just under 30% (OBR).
Planned issuance for 2025–26 totals £231.7 billion, of which only 6.8% is index-linked (DMO).
Market Trends
Gilt yields remain elevated: in early 2025, 10-year yields were near 4.9%, while 30-year yields exceeded 5.5%.
The OBR projects total debt interest spending at more than £600 billion over the next five years.
June 2025 borrowing came in at £20.7 billion, £6.6 billion higher than June 2024, mostly due to rising debt interest (ONS/Guardian).
In 2025–26, the UK is set to spend about £111 billion on debt interest, making it one of the largest items in the budget. That’s more than the entire education budget, almost double defence, and over twice transport or policing and justice. Only the NHS is bigger, at around £165 billion, with debt interest now two-thirds of its size. Put simply, roughly one pound in every eight of public spending goes on interest, a bill that has risen by more than 100% in just six years and, unlike health or schools, delivers no new services—just transfers to bondholders, banks and overseas investors.
At-a-glance table
Metric Value Timeframe Debt interest forecast £111.2 bn 2025–26 (OBR) Interest (monthly) £16.4 bn (June); £7.1 bn (July) 2025 (ONS) APF gilt holdings £586.4 bn 20 August 2025 (BoE) Bank reserves ~£760 bn (neutral ~£550 bn) 2025–26 estimate Overseas gilt holdings 31% (£635 bn) Q2 2024 (ONS/OBR) New issuance (index-linked) 6.8% of £231.7 bn 2025–26 (DMO) 5‑year debt interest projection ~£600 bn Through 2030 (OBR)
These figures illustrate the current (at the time of publishing) size of the burden and how the “leaks” translate into real, measurable costs.
What’s the fix?
The solutions do not lie in theatrics. Printing money or defaulting would backfire, making borrowing costlier and leaks worse. The answer is plumbing. The Bank can stop paying the full policy rate on every pound of reserves, paying only on the slice needed for stability. The Treasury can lengthen the maturity of debt at favourable times, reduce reliance on index‑linked bonds, and, over time, swap legacy RPI‑linked debt into more stable forms. National Savings can be used more cleverly to tap household funds without overpaying. Foreign participation can be secured on better terms by making issuance more predictable and by offering other sterling assets beyond gilts. The Bank and the Treasury can build a loss buffer so taxpayers are not whiplashed by swings in the Bank’s portfolio.
The bottom line is that debt interest is not just a neutral accounting item. It is a set of pipes and leaks. Some aspects require maintaining confidence, while others can be improved through better design. In a world of higher rates, plugging leaks is not optional; it is the only way to keep the bucket from draining dry.
We aim to continue breaking ground in this series by demystifying the economic reality of government policies, because there are serious issues that need to be addressed.