Centre for Public Policy

Blog by Professor Sir Anton Muscatelli, Principal and Vice-Chancellor of the University of Glasgow

A couple of weeks ago, alongside a number of other economists, I signed a letter to the Financial Times setting out why our current fiscal rules in the UK penalise investment and will be a hindrance to the Labour Government’s growth mission.

Fiscal rules are there for a very good reason. In essence fiscal rules prevent governments from having a bias towards fiscal deficits, as political pressures tend to tempt them to take an optimistic view of future tax revenues to cover spending plans. In their current guise, they have been a part of the UK policy landscape since 1997, when the Labour Government introduced them to persuade markets that they were serious about avoiding this trap. Indeed, most OECD countries have adopted some type of self-discipline of this type, and in 2022 the IMF noted that at least 105 countries around the world have at least one fiscal rule.

But the counter to this, as we argued in our FT letter, is that the rules can prevent you from taking investment decisions which will benefit economic growth, and which will actually improve the public finances in the long run. No fiscal rule can be designed in a way which is optimal for all time. Indeed, as two of our co-signatories of the FT letter discussed back in 2015, when interest rates were close to zero (as was the case for some time after the Great Financial Crisis), then fiscal rules can be too tight in terms of managing the economy.

At the present time, the one aspect of the UK’s fiscal rules which is most worrying for public investment, especially for a government focused on pursuing a growth mission is the Debt Rule, which focuses on the Debt-to-GDP ratio. The current version of the rule requires the ratio to fall by the fifth year of the forecast by the independent fiscal watchdog, the Office for Budget Responsibility (OBR). This is not a very good rule. (As it happens it’s not a great rule in terms of ensuring fiscal discipline even in good economic times as it exerts little constraint in the first four years of the forecast.) But it’s a particularly bad rule in current times where a government has been elected with a strong mandate to try to bring down the Debt-to-GDP ratio by regenerating economic growth. It biases strongly against any investment which has an impact of growth outside the 5-year window, which includes net zero investments. The way to bring our indebtedness down as a country is by growing national income, the denominator of this ratio.

So what could be done to ensure that the government does not have an incentive to under-invest?

First, on the Debt rule, one way would be to give more power to the OBR to assess whether the path of the Debt-to-GDP ratio is rising unsustainably. The OBR would assess the Debt-to-GDP ratio not over a fixed period of 5 years. It could produce a more nuanced assessment over different horizons, of up to 7-10 years. The OBR would be asked to comment publicly on the path of the debt ratio following fiscal events like the Budget and the Spending Review and assure the Treasury that in its view it seems sustainable given different potential interest rate and growth scenarios.

Second, as an input to these calculations, the Treasury would present to OBR in preparation of their forecasts the range of public investments being considered, and OBR would be asked to comment publicly on their assessment of the major investment elements of those fiscal plans (including the potential leveraging of private investments) and how this will affect the path of GDP and hence the debt ratio. This creates an incentive within government to focus on those investments which are more productive for growth.

Third, as a complement to this, and given the imperatives of net zero, OBR could ask for input to these considerations from the UK Climate Change Committee to ensure that the investment plans being presented are broadly consistent with the UK’s longer-term statutory obligations to achieve Net Zero.

There are of course other ways of doing this. Instead of the Debt-to-GDP ratio, one could design a system which focuses on public sector net worth, which looks at whether the fiscal plans will improve this. As noted by the NIESR, this was considered in 1997 but no progress has been made on looking for alternatives to the Debt-to-GDP ratio.

It does look possible that the Labour government will go in this direction. At the time of writing Rachel Reeves has indicated in her speech to the Labour Conference that she is interested in finding measures of how investment will benefit the country. This gives considerable hope for optimism. It’s time for the UK to revise its fiscal rules to ensure that they meet our current economic needs.

 

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ICYMI: Spotlight On the Election: The Economy and Living Standards

You can listen to Sir Anton speaking with Kezia Dugdale, Associate Director of the Centre for Public Policy, in a recent episode of ‘Spotlight: On the Election’. The episode recorded before the election covers the big economic challenges facing the parties and the potential policy solutions for the next government.

Listen and subscribe

First published: 24 September 2024