It’s time to rewrite the UK's fiscal rules
For many years, the UK economy has been marred by low growth and flatlining productivity, both by historical and international standards. We’ve been lagging behind other developed economies, and it is making it difficult for everyone to make ends meet.
With GDP per head currently below where it was at the last general election, the average person is now worse off than they were five years ago. This matters because it puts real pressure on public finances.
When the economy underperforms, it means a smaller tax base and less money flowing into public coffers. This limits the government’s capacity to invest in crucial areas like healthcare, education and infrastructure.
This predicament is exacerbated by the UK government’s current fiscal rules. As things stand, the ratio of public debt to GDP should be falling within a five-year horizon and the ratio of the deficit to GDP should be below three per cent by the end of the same period.
These rules discourage public investment by targeting the overall deficit rather than the current deficit. But borrowing to fund investment is not the same as borrowing to fund consumption, because the former can increase output in the long run while the latter does not.
This bias against public investment creates a vicious cycle. Poor economic growth means lower tax revenues. To meet the current rules the government must cut spending. But because the payoffs to public investment fall outside of the five-year window, while the costs do not, the government scales back its investment expenditure. This leads to poor economic growth, and so the cycle continues.
Given these challenges, it is clear that a new approach is needed. A revised fiscal framework can play a vital role in fostering sustained economic growth. This new framework would rest on the following three pillars:
1. Discount Public Investment from the Current Targets
By removing public investment from the fiscal targets, the government has greater scope to invest in projects that drive long-run growth.
The current rules hamper economic growth by excluding the impact of projects that would lower the debt-to-GDP ratio beyond the five-year window.
For example, the United Kingdom is legally obligated to reach net zero by 2050. This target will only be met if supported through well-judged public investment in green infrastructure. Such investments could be made exempt from measures within the existing targets.
2. Fixed Schedule for Fiscal Events
Establishing a fixed schedule for fiscal events, determined well in advance, can provide much-needed economic stability.
Clear communication on the timing of fiscal announcements creates predictability which can boost investor confidence and create an environment conducive to growth.
The Treasury should be empowered to establish a fixed schedule for fiscal events so that their timing is insulated from political manoeuvring, in the same way that meetings of the Bank of England’s Monetary Policy Committee are scheduled many months in advance.
3. Incorporate Public Sector Net Worth as a Target
Including public sector net worth as a target means looking at the government’s balance sheet, its assets minus its liabilities. This means comparing two stocks, as opposed to the debt-to-GDP ratio which compares the stock of debt to the yearly flow of income.
This shifts the focus away from year-to-year budget balancing to a broader measure of long-run fiscal sustainability inclusive of what the government owns and what it owes.
Including this as a target could help incentivise sustained public investment, which is low by comparable international standards.
The UK government’s economic challenges are significant, but not insurmountable. By adopting a revised fiscal framework, based on these three pillars, it can create a more robust economic environment which emphasises long-term growth. Rules are there for a reason: but getting them right is crucial.
Dr Benjamin Caswell is a Senior Economist working in the Macroeconomic team at the National Institute of Economic and Social Research.
