Fiscal rules are a key tenet of UK policy. But what are they and why were they introduced? In the aftermath of the 2024 budget, Professor Phil Tomlinson, Co-Director of the Centre for Regulation, Governance & Industrial Strategy, explores their history and future.
After weeks of speculation, UK Chancellor Rachel Reeves confirmed changes to the Treasury’s ‘fiscal rules’ in the 2024 budget. Her goal is to facilitate new public investment.
Quite simply, fiscal rules aim to ensure governments balance their annual budget, and that long-term public debt is properly managed. Public debt is usually measured relative to the size of the economy, or gross domestic product (GDP).
When the government runs a budget deficit, this leads to higher public borrowing and long-term debt. Though whether the debt/GDP ratio rises or falls depends on the overall economic cycle.
Back to the beginning
Fiscal rules have, in various guises, been part of UK fiscal frameworks since being introduced by then Chancellor Gordon Brown in the late ‘90s. They are designed to prevent governments from increasing public borrowing for short-term political advantage, such as for pre-election tax cuts.
Some economists also believe higher levels of public debt can become unsustainable and will be a burden on future generations. In 2024, annual interest payments on UK public debt alone accounted for 8.4% of all government spending. This is almost the combined budget for the nation’s defence and public transport.
Gordon Brown’s ‘golden rule’ was that government borrowing would only pay for public investment and not day-to-day spending over the ‘economic cycle’. The debt/GDP ratio was also capped at 40%.
Yet, the time frame of the economic cycle was often altered by the Treasury. This led to accusations that the rule was being manipulated and, on several occasions, not actually being met. Following the Great Financial Crisis, and rising levels of public debt due to state banking bailouts, the golden rule was abandoned.
Current rules
Since 2010, the Office for Budget Responsibility (OBR) has acted as an independent watchdog. The intention was to bring greater transparency to the process, while also producing forecasts on the future state of public finances and the economy.
Under Jeremy Hunt, there were two fiscal rules. The first was to balance the budget so that ongoing public spending was met by tax revenues. The second was that the public debt to GDP ratio should be falling in the fifth year of the OBR forecast.
Both are problematic. The first rule can fall foul of the economic cycle, since in downturns both the budget deficit and debt/GDP ratio will rise due to falling tax revenues and higher state benefits being paid out, while GDP sinks.
Moreover, even in slow-growing or stagnant economies (like the UK), rising budget deficits and debt/GDP ratios can become endemic. This is especially the case if a country has an ageing population, which raises demands on public finances (older people tend to rely more on public services and state benefits such as pensions).
These structural issues exacerbate the problems with the second fiscal rule – which is highly restrictive and instils an inherent bias against public investment.
Faced with a higher-than-normal budget deficit and a forecasted higher debt/GDP ratio, chancellors are tempted to cut current investment, harming growth. Moreover, these forecasts are often sensitive to small changes in interest rates and growth and have often proven wide of the mark.
The investment gap
The wider problem is that since the Great Financial Crisis, UK economic growth has been weak. Much of this stems from weak productivity (that is, output per hour worked). This is related to the UK’s very poor record on private and public investment.
A recent report from the Institute for Public Policy Research (IPPR) notes the UK has trailed other major G7 economies on business investment since the mid-‘90s, and now ranks 28th of 31 OECD countries.
Indeed, since 1990, the UK’s investment gap with the OECD average is estimated to be around £35 billion per year. This means British workers are using outdated equipment and, as such, are less productive.
Many economists now agree the UK is in desperate need of new public investment, especially in infrastructure and connectivity, and to support emerging high-tech industries.
Yet, to meet the current public debt rule, total public investment over the next five years would have to fall from 2.5% to 1.7% of GDP. In real cash terms, this cut would be more than under the entire Conservative government of 2010-24.
History suggests the way to reduce the debt/GDP ratio is through economic growth, rather than cutting public investment.
Former Bank of England chief economist Andy Haldane has also recently highlighted OBR analysis on the likely returns of increased public investment: a permanent increase in public investment of 1% of GDP goes on to increase GDP by 0.5% after five years and over 2% after 10-15 years.
Revised frameworks
Most economists agree the government needs to have a credible fiscal framework in place and this may need some independent oversight. The catastrophic Truss/Kwarteng budget in 2022, which ran roughshod over the OBR and spooked markets, lives long in the memory.
Yet the underlying problem with the existing fiscal rules is that they are one-sided. They focus on excessive borrowing yet ignore the other side of the government’s balance sheet.
Indeed, the National Institute of Economic and Social Research (NIESR) have advocated using public sector net worth as a target. This means evaluating the whole government balance sheet (including non-financial assets such as roads, hospitals and schools), minus debt liabilities.
While the latest budget does not go this far, it does address some of the concerns about low public investment. The first rule – what Reeves calls the stability rule – will remain in place but the Treasury will change the way debt is calculated to provide more flexibility to increase public investment.
In effect, some government assets will now be used in calculating debt, which will be relabelled as ‘public sector net liabilities’. The change still aims for debt/ GDP to fall over five years, but this accounting change has allowed the Chancellor to announce an additional £100 billion in new public investment.
However, market sentiment may still restrict the amount that is forthcoming – a pity, since in the long run such investment leads to higher growth and becomes self-financing as the economy benefits from higher tax revenues.
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