Public Debt Sustainability and Fiscal Rules
Given the current discussions about possible tax cuts at the forthcoming budget in March and whether or not there is enough ‘fiscal space’ for these, our Deputy Director for Macroeconomic Modelling and Forecasting, Stephen Millard, asked Senior Economist Ben Caswell to talk him through the issues around fiscal sustainability and the fiscal framework.
Why is public debt sustainability crucial for the government?
Public debt sustainability is vital because it determines the ability of the government to respond promptly to economic shocks and to fund long-term public investment projects. Therefore, sustainable public debt is not an end in itself but a means to ensure that the government has the fiscal space to utilise taxation and spending as effective tools of economic management.
However, public debt sustainability is a complex artefact, composed of both past actions and future expectations; it depends crucially on the belief of whether debt-to-GDP will grow without bounds. It is therefore governed by the credibility of long-run tax revenue and spending paths and the attitude of financial markets to the underlying health of the economy.
Markets sharply differentiate between credible and non-credible fiscal paths, as demonstrated by the September 2022 Mini-Budget. If investors have doubts, they will substitute UK bonds for other bonds and borrowing rates will escalate as the market quickly becomes illiquid. This limits the fiscal space of the government and constrains optimal policy choices.
How does the UK’s current fiscal framework restrict long-term public investment?
The UK’s fiscal framework mandates that the debt-to-GDP ratio should be falling at the five-year horizon and that net government borrowing should not exceed 3 per cent of GDP at the same time. Therefore, any public works 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 Treasury’s fiscal mandate. However, the vast majority of public investment projects have a time horizon beyond five years.
Furthermore, public investment can raise productivity and long-run output. Therefore, unlike discretionary spending, public investment can raise the denominator of (and therefore downward pressure on) the debt-to-GDP ratio in the future.
With the single-minded focus on five-year rolling targets, the existing fiscal framework does not account for the reason why government debt is issued or the structure of that debt. While this framework seems prudent at first, it falls victim to short-term thinking by overlooking the returns which can accrue from public investment beyond a five-year horizon.
How could the UK’s fiscal framework be adapted to support long-term objectives in a better way?
This inability to integrate medium to long-term fiscal objectives into the existing framework should give cause for a rethink. For example, as part of the green transition, the UK 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.
So, the fiscal framework could be adapted to allow for this by, for example, taking green infrastructure investment out of the debt measure used within the existing targets. As long as there are idle resources in the economy and well-defined objectives for using government borrowing, there is no immediate threat of bond markets turning illiquid, providing the advice of our independent economic institutions are respected.
Alternatively, the government could adapt its fiscal framework to incorporate public sector net worth as a target. The inclusion of public sector net worth in the UK’s fiscal framework would provide a broader measure of public debt sustainability which is inclusive of what the government owns and what it owes. As domestic public sector net worth is relatively low by comparable international standards, the inclusion of this as a fiscal target could help incentivise long-term public investment expenditure in the UK economy.
How robust would public debt sustainability be to changes in the UK’s fiscal rules?
UK public debt is neither at crisis point nor is the situation desperate. The maturity structure of UK debt is good and both domestic and international demand for UK bonds remains buoyant. In light of this, we should not be overly worried about public debt becoming unsustainable. What we ought to consider is moving towards incorporating medium and long-term objectives into our fiscal framework to better enable us to meet our long-term economic goals.
While traditional measures of public debt, such as the debt-to-GDP should remain as an important component of any new fiscal rules, it ought to be considered alongside other targets, such as public sector net worth. The real long-term risk arises from an excessive singular focus on debt-to-GDP ratio targets at the expense of public investment to raise productivity and long run output.