‘A fiscal rule shakeup would unlock cash. But what could the new rules be?’

“It is time the Treasury moved on from just counting the costs of investments, to recognising the benefits too.”

Since Chancellor Rachel Reeves uttered these words in her speech to Labour Party conference, hinting at a long-awaited reform to the UK’s fiscal framework, many of the UK’s top economists, institutions and media commentators have been lining up to propose their favourite new configuration of fiscal rules.

The context was that before the general election Reeves committed to have debt as a percentage of GDP falling between the fourth and fifth year of a forecast produced by the Office for Budget Responsibility. 

But she didn’t specify which measure of debt should be falling. Now, many options for reform are on the table and Labour is widely expected to change the definition of public debt to unlock more borrowing for public investment.

UK fiscal rules drive a cycle of underinvestment

To understand the debate it is important to understand the interaction of the UK’s fiscal rules with investment spending in recent years. The UK’s current set of fiscal rules incentivise governments to cut investment spending to ‘balance the books’ in the short term, even when that investment would increase productivity, growth, tax receipts and the sustainability of public debt over the longer term. 

Investment is crucial for building and maintaining the foundations for the economy – providing the bedrock underpinning productivity and growth. But chronically low investment from both the public and private sectors has led to the economic stagnation we see today.

The government needs more public investment to escape a low growth trap and, ultimately, spark the kind of economic revival that will be crucial for the chances of winning a second term. 

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That is why on Sunday, 70 MPs from the Labour Growth Group, including Josh Simons and Torsten Bell, wrote to Chancellor Reeves to express their support for rewriting fiscal rules so that billions can be invested in public services and infrastructure. Interestingly, they pitched reforms to the fiscal rules as part of a ‘change’ message on the economy (whereas previously fiscal rules have been part of a continuity/stability message):

“If we are to achieve the growth we need we must now show global investors we are serious about breaking with the past. While voters must know that they can expect a future of better living standards and public services under Labour.” 

“…Time is of the essence – the sooner we invest, the sooner our constituents will begin to benefit from that investment in their communities. If we delay, we risk further entrenching the barriers to growth that have held our country back for too long. We say this upcoming budget is the time to grasp the opportunity before us and act with conviction.”

The letter came after new analysis from LSE’s Centre for Economic Transition Expertise (CETEx) showed that inherited plans to cut public investment will jeopardise the government’s mission to achieve the strongest growth in the G7. It calculated that, even in a best case scenario, sticking with the previous government’s proposed cuts could reduce potential GDP by nearly £10bn after five years, rising to over £23bn after a decade. 

This is why many economists are arguing that sticking with these cuts would lock Britain into another lost decade of stagnation that the country can ill afford.

One option for the government

One proposal growing in popularity is to swap the target to have public sector net debt falling in five years for a target to have Public Sector Net Worth rising after five years. 

Public Sector Net Worth broadens the definition of debt to include more government assets (such as student loans, guarantees to businesses and more illiquid/non-financial assets like equity stakes in companies or the value of the public transport network and other infrastructure).

A timely paper from IPPR explains that a Public Sector Net Worth (PSNW) target would give investors a better picture of the government’s true financial position – just as they take a company’s assets and growth strategy into account when valuing it, not just its borrowing. 

They found moving to a net worth rule could allow the Chancellor to borrow £57bn more for investment than under the current debt rule, and highlighted research from the IMF that fiscal rules based on PSNW are “more conducive to public investment and economic growth”.

PSNW has enjoyed heavyweight support from the Institute for Public Policy Research (IPPR), Martin Wolf, former Bank of England Chief economist Andy Haldane and their former governor, Mark Carney, and OBR head honcho Richard Hughes (writing for the Resolution Foundation before his current role). 

Ahead of the government’s international investment summit on October 14, a group of pension investors managing £1.7tn of assets also called for targeting Public Sector Net Worth.

Additional tweaks to reform the fiscal framework

An alternative, more incremental option being floated is to target Public Sector Net Financial Liabilities, which leaves out hard-to-value assets like buildings and infrastructure, but it does include financial ones like stakes in companies’ equity held by public sector banks.

However, there are lots of additional options which could help us move away from our anti-investment fiscal framework. 

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The government could also remove the liabilities of its public banks like the National Wealth Fund from the debt rule, as the German government does, and/or exclude the Bank of England’s losses from selling the bonds it bought during quantitative easing from debt calculations.. 

And they could extend the debt horizon beyond 5 years to give more time for public investment to demonstrate growth effects and become more self-financing, as recently proposed by the FT and Bloomberg. None of these are mutually exclusive. 

All eyes on the budget

October 30 will be the first time Labour have had control of tax and spending decisions in nearly a decade and a half. They have an opportunity to signal an alternative economic approach 16 weeks after winning the election (and potentially reverse some of the ‘doom and gloom’ headlines since cutting the Winter Fuel Payment). 

Any change to fiscal rules could signal that the new government appreciates how borrowing to invest contributes to growth, tax receipts, fiscal sustainability and ultimately, a better society. 

This article was written by multiple staff at the New Economy Brief, part of the Economic Change Unit.

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