The Case for a New Fiscal Framework

With the election campaign up and running, our Deputy Director for Macroeconomic Modelling and Forecasting, Stephen Millard, asked Senior Economist, Benjamin Caswell, for his views on the key issues around fiscal policy and the fiscal framework that will be faced by whichever party finds itself in power on 5 July.

Post Date
10 June, 2024
Reading Time
7 min read

In the early phase of the Election Campaign, both parties have talked about policies that require extra government spending. But how much room for manoeuvre will there be for an incoming Chancellor, given that neither party wants to raise tax rates?

NIESR’s Spring 2024 UK Economic Outlook forecast indicates that current government spending plans do not meet the current fiscal rules, which suggests there is essentially no room to manoeuvre.

Meanwhile, there are rising claims on government spending, for example, the urgent need to enhance healthcare, social care, and education services; significant investments in infrastructure, particularly outside of London; enhancements in skills crucial for addressing the productivity gap; commitments to green investments for achieving net zero targets; and increased defence spending due to escalating geopolitical tensions.

This means that it is highly likely that the winners of the next general election will have to raise taxes if they wish to maintain the existing provision of government services. Despite this, both main parties have ruled out raising income tax, national insurance and value added tax. These taxes account for around three-quarters of the UK government’s tax revenue, while the remainder is made up of smaller miscellaneous taxes, ranging from fuel duty to inheritance tax.

If both parties stick to their pledge, there are few remaining tools at their disposal for raising revenue. While we anticipate a detailed list of costings to be published in the upcoming election manifestos, both parties have currently pledged to raise national defence spending to 2.5 per cent of GDP, up from where it currently stands at 2.3 per cent of GDP. This amounts to an additional 4.5 billion pounds. Although this accounts for only half a per cent increase in the government’s expenditure, this is non-trivial given that there is currently no headroom against the government’s current fiscal rules, particularly after the two national insurance tax cuts over the last year.

Why are these fiscal rules in place?

These rules are in place to guide the government towards a sustainable budgetary position and to act as a commitment device to boost confidence among international investors. By sending out a signal to international markets, these rules communicate that the UK government is responsible in its fiscal management. As a result, the fiscal rules are thought to engender an environment of stability which is conducive to investment and economic growth.

However, these rules, which have been a feature of UK policy since the 1990s, have been far from static. As opposed to being determined by legislation, they are set by the Chancellor and over the decades have been subject to a number of revisions and readjustments depending on the incumbent government’s fiscal strategy and the economic climate.

For example, the current rules, which were last tweaked in 2022, mandate that 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.

However, whether these rules are fulfilling their alleged purpose is questionable. Specifically, they do not appear to be functioning as an effective commitment device. This is due to an incentive structure which generates unrealistic proposed expenditure reductions to take place in the fifth year of the rolling forecast to ensure that the targets are being met on paper. However, as spending plans are not fixed five years ahead of time, often there are large revisions to government expenditures by the time the fifth year is reached.

Why do these fiscal rules as currently structured act as a deterrent to public investment?

The current fiscal rules discourage public investment because they target the overall deficit rather than the current deficit. Subsequently, any public investment project that does not generate an increase in output which lowers the debt-to-GDP ratio within a five-year horizon is at odds with the fiscal mandate.

Therefore, the existing rules can hamper economic growth itself by inadvertently placing unhelpful constraints on public investment. Specifically, during economic downturns, these rules disproportionately favour reductions in investment expenditure as they demand improvements in the debt-to-GDP ratio within a short five-year timeframe.

This creates a de facto pro-cyclicality for public investment as during periods of economic contraction, tax receipts typically fall and thereby limit fiscal headroom. This has the potential to amplify swings in economic cycles if the government already has little fiscal room to manoeuvre. If public investment is then scaled back during a downturn alongside private investment, this can hinder an economic recovery and limit potential long run growth.

However, it is not just about the debt-to-GDP ratio. Public investment is also constrained by the three per cent deficit-to-GDP ratio target. As the deficit must be below three per cent at the end of the rolling five-year horizon, often public investment projects are scaled back, for example, the cancellation of the northern leg of HS2.

However, 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 can create 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 to meet the deficit-to-GDP target.

Why don’t you tell me some elements of the alternative fiscal framework that you’d like to see in place?

A revised fiscal framework could play a vital role in fostering sustained economic growth. Three important elements of a revised fiscal framework are the following:

Firstly, discounting 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.

Secondly, establishing a fixed schedule for fiscal events. Setting a fixed schedule for these events, determined well in advance, can provide much-needed economic stability for the UK economy. Clear communication on the timing of fiscal announcements creates predictability which can boost investor confidence and create an environment conducive to growth. Moreover, establishing a fixed schedule for fiscal events ensures that their timing is insulated from political manoeuvring, in a similar way to how meetings of the Bank of England’s Monetary Policy Committee are scheduled many months in advance.

Thirdly, incorporating public sector net worth as a target. This means looking at the government’s balance sheet, its assets minus its liabilities. Comparing two stocks, as opposed to the debt-to-GDP ratio which compares the stock of debt to the yearly flow of income, 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 and economic growth, particularly as UK public sector net worth is low by comparable international standards.