The Chancellor Has Tied Her Own Hands With Her Fiscal Rules - Here's Why She Should Change Them

12th July 2024

The new government has made boosting economic growth its central goal. Chancellor Rachel Reeves wasted no time in announcing changes to the planning system designed to encourage more housebuilding and infrastructure investment.

And she has met business leaders to unlock more private capital, including through their contribution to a national wealth fund.

But government also has a vital role in boosting growth through its own investment. UK public investment is already well below the G7 average, and is set to fall, even with Labour's planned green investment. This has contributed to the country's dismal record on productivity growth since the financial crisis.

However, the chancellor has tied her hands when it comes to increasing government investment through a set of self-imposed fiscal rules, which set strict limits on how much the government can borrow to spend and invest.

Reeves has said she is determined to be the "iron chancellor", striking a sharp contrast to former PM Liz Truss, whose unfunded borrowing for tax cuts spooked financial markets and raised interest rates.

But many academic experts and think tanks, as well as a number of high-ranking officials in the Treasury and the Bank of England have argued that the fiscal rules are not fit for purpose.

They argue that the rules should be better shaped to meet Labour's key goals. And there is evidence that the financial markets are relaxed about the government borrowing more money if it boosts economic growth.

The fact is that the fiscal rules are not set in stone. Since they were introduced by Gordon Brown in 1997, every chancellor has changed them to reflect changed economic and political circumstances.

Flawed rules
There are two fiscal rules that must be met, inherited from the previous government. But Reeves has made a significant change to one of them.

She now says that while the government should continue to aim to balance yearly taxes and spending (reducing the yearly deficit), capital spending (for example, on infrastructure) will be exempted.

But she is still bound by her other fiscal rule, which says that debt must start falling in five years as a percentage of GDP (that is, the size of the economy). Weak growth means that Reeves' space for any further borrowing is severely constrained.

This creates a real dilemma for the chancellor. If the economy is not growing, the government is unable to invest enough to help it grow. But in the long term, further investment would create a virtuous circle where higher growth would allow more government spending and borrowing.

There are several other problems with this debt rule. For a start, unlike the first rule, it does not distinguish between capital and current spending, and does not count government assets as well as liabilities. For example, building more council houses or roads is costly, but produces a valuable asset.

Another problem is that the Office for Budget Responsibility (OBR), which crunches the numbers and advises the government on whether it will meet its fiscal rules, admits it is not possible to make exact economic predictions for five years in the future (and it rarely has).

Also, the OBR is powerless to question the government's spending plans, or some of its plans on tax. This allows the chancellor to game the system by forecasting unrealistic spending plans or tax rises that never materialise.

And in each budget, the government can negotiate with the OBR over how it might shift its forecast to allow more "headroom", leading to short-term changes every year in both taxes and spending. As long as they distort long-term government decisions, the current rules are really not that credible.

Possible changes
In order to stick to her rules, the new chancellor is planning to borrow only an extra £3.5 billion per year to help fund the national wealth fund and the government-owned Great British Energy - a tiny increase compared to the £136 billion in capital spending already allocated.

Although the private sector can add to these projects, for example by getting UK pension funds to invest more in housing and infrastructure, there are limits to how much they will put in without a big enough financial return.

Experts estimate that changes in the fiscal rules, particularly the debt rule, could free up £30 billion a year in capital spending, taking the UK closer to its main rivals and unlocking more private investment.

These changes could include a new way of calculating government debt that includes its assets (therefore making the debt smaller); a more flexible forecast giving a range of possible outcomes; and more oversight by the OBR of spending and tax decisions. The changes would strengthen the credibility of the fiscal rules and would be in line with the practices in many other advanced economies.

Another change could be made to the way the government sets out its future spending plans (which set departmental budgets). This would separate out the kind of departmental spending that has long-term social benefits and could lead to reductions in government spending.

These might include more NHS spending on prevention and more money for early years education and skills training. One proposal, suggested by former Treasury official Caroline Slocock, who helped design the spending system under former PM Gordon Brown, would be to ringfence such spending and take a 10-year perspective on its impact.

Author
Steve Schifferes
Honorary Research Fellow, City Political Economy Research Centre, City, University of London

Note
This article is from The Conversation web site. To read it with links to more information go HERE