The UK government budget came in below its annual borrowing target by £700m, official figures show – but the Iran war is likely to blow a hole in Rachel Reeves’s carefully calculated fiscal “headroom” over the coming months.

The government borrowed a net total of £132bn for the financial year ending in March, the Office for National Statistics (ONS) said. This slightly undershot the £132.7bn that the Office for Budget Responsibility (OBR) had forecast just last month.

The total was £19.8bn less than the £151.9bn borrowed in the previous financial year, after rounding, although it was still the sixth highest on record.

The figure was the lowest in three years and the best result since Labour came into power in July 2024. The last time it was lower was in the year to March 2023, when the government borrowed £127.3bn.

“The headline numbers coming in lower than the OBR’s expectations for the year as a whole will be a welcome boost to the chancellor,” Elliott Jordan-Doak, a senior UK economist at Pantheon Macroeconomics, said.

For the month of March, public sector net borrowing – the difference between spending and income – was £12.6bn, which was £1.4bn lower than a year earlier and the lowest since March 2022. City economists had expected the March figure to be lower, however, at £10.3bn.

The annual figure was better than economists had expected, partly due to revised borrowing figures by ONS for previous months, as well as higher tax receipts and lower debt interest payments.

James Murray, the chief secretary to the Treasury, said: “Our deficit is down £19.8bn because of our plan to cut borrowing. In a volatile world the decisions we are taking are the right ones to keep costs down, take back our energy security and cut borrowing and debt.”

Reeves announced £26bn in tax rises in her budget in November to lower debt and offset rising government spending on public services and upgrades to the UK’s infrastructure.

The government also made £8.5bn from inheritance tax in the financial year, up by more than £200m, as frozen thresholds mean more families are hit by the tax.

In a sign people are perhaps using cars less to cut down on petrol and diesel usage amid rising costs, the amount collected in fuel duty in March was the lowest for any month since July 2023.

Reeves has implemented a fiscal rule that requires the government to fund day-to-day spending with taxes by the end of the parliament. The government’s day-to-day spending rose by £65.6bn, or 6.4%, in the year to March.

In February the chancellor announced that her buffer – or headroom – to meet this rule by 2030 had increased in its latest projections to £23.6bn, from £21.7bn at the time of the November budget.

However, the conflict in the Middle East is expected to jeopardise this headroom, with rising inflation and potential job cuts as well as higher interest rates eating into this target.

Ruth Gregory, the deputy chief UK economist at Capital Economics, said: “We do not expect this improvement to last long. We think the energy price shock will mean that borrowing overshoots the OBR’s forecast by a huge £29bn for the 2026-27 fiscal year and by about £13bn in subsequent years.”

Companies in the UK are already experiencing sharp increases in costs as the Iran war drives up energy prices, according to a separate closely watched survey of business activity in the UK.

The monthly purchasing managers’ index, compiled by S&P Global, found that firms in the UK’s dominant services sector were hit with the biggest jump in costs since 1996 between March and April. Prices also rose “rapidly” for raw materials in the manufacturing sector.

Activity overall across the UK’s services and manufacturing sectors fared better than expected, reaching a balance of 52 in April, from 50.3 in March. Any reading above 50 represents growth.

Economists had expected the index to decline to 49.9. The survey said the rise was partly due to customers rushing to secure purchases ahead of feared price rises linked to the war.