Fiscal policy for an activist state

The Labour party’s 2017 manifesto promised a decisive shift in the economic role of the state. The party promised a major increase in capital expenditure with the creation of a National Transformation Fund, a National Investment Bank with a capitalisation of £250bn, a big rise in R&D spending and the creation of publicly-owned enterprises in key sectors including rail, post, energy and water.

Labour is also committed to fiscal responsibility however and the party needs to develop its plans for a more activist state in a way that is compatible with prudent controls on the public finances. This is the right thing to do for future generations but it will also be essential in the short term to give markets confidence as they adjust to the novel context of a Corbyn government. Economic activism and fiscal prudence will need to go hand in hand.

But that does not mean accepting all the rules and conventions of the public finances that we have today. Labour has already said it will set fiscal rules that are more accommodating to public investment. But to achieve its goals there are other ways in which the UK’s fiscal and public accounting framework will need to change.

Public enterprises

When it comes to fiscal policy the UK treats publicly-owned businesses no differently from government delivery paid for by taxpayers. This is because we report and target debt for the whole public sector including public corporations (an exception is made for state-owned banks and Labour’s investment bank which will borrow commercially should be included in this category).

By contrast the EU and most advanced economies measure debt with respect to the narrower concept of ‘general government’ – ie national, devolved and local administrations excluding public enterprises. Additionally, our headline measure of public debt only reports liquid financial assets and liabilities. So, if the government borrows to buy or create a non-financial asset the public finances appear to worsen, even if the real economic effect is neutral or positive.

The transfer of Network Rail in 2014 into the public sector is a good example of the combined effects of these policies. The move was presented as detrimental because it increased public sector net debt by £30 billion (about 2 per cent of GDP) and annual borrowing by 0.2 per cent of GDP. But the public sector also took on Network Rail’s assets which are valued at £280 billion in the 2015/16 whole of government accounts. It is hard to see how the transfer diminished fiscal sustainability.

By targeting public sector net debt, the Treasury has created a presumption against the state taking on extra liabilities even when they are more than matched by assets or future revenue streams. Under a future Labour government, decisions about nationalising businesses or creating new public enterprises should be based on a true economic appraisal of the costs and benefits, not the artificial pressure of fiscal and accounting rules. Labour should therefore consider using a basket of indicators that paint a fuller picture.

For example it could report on general government debt as well as public sector debt so the impact of public enterprises on liabilities is transparent. This would allow these businesses to take on debt to finance commercially sound investments without such tight control from the Treasury. The government’s main focus with respect to these companies should be the potential cost of contingencies in the event of problems, not their impact on the national debt when all is well. Additionally, a future government should also target a broader measure called Public Sector Net Worth, which includes assets as well as liabilities. This would mean that borrowing to acquire productive assets would be viewed more positively than ordinary deficit spending.

Adopting a scorecard of debt measures matters because Labour will breech its proposed public debt rule if it is based on the current measure of public sector net debt. The party has promised that debt will fall between the start and end of each parliament but large-scale nationalisations will push up this definition of debt a lot. A broader basket of measures would allow Labour to exempt specific transactions from its rule, if they could be shown to have no negative impact on other debt indicators. But this whole initiative must be pursued in a spirit of transparency not obfuscation. It will be essential that the Office for Budget Responsibility (OBR) signs-off and scrutinises all decisions.

Public investment

Labour’s other fiscal rule on borrowing departs from present Conservative policy in order to increase capital expenditure. It permits a future government to borrow to invest by mandating that only the current budget should be balanced within five years. This leaves room for a great deal of extra public investment – indeed significantly more than Labour promised in 2017.

At the level of individual projects there should be a presumption in favour of investment whenever a project has a clear financial or social return for government. The case for social housebuilding illustrates the point because investing in social housing generates future rents, lowers benefit expenditure and brings broader social and economic benefits. The National Infrastructure Commission and similar bodies should lead on the appraisal of viable projects.

But there may also be a case for revising how the fiscal impacts of investment decisions are assessed. Taking account of the assets created as well as the liabilities is obviously important, as discussed already – the fiscal framework should report the the impact of investment on net worth not just public debt. But a pro-investment fiscal framework also needs to factor in the impact of capital spending on growth. At present the OBR’s economic forecasts reflect the economic and revenue impacts of capital investment in boosting short-term demand. But the office does not publish alternative scenarios for the UK’s long-term growth and associated fiscal sustainability under different public investment strategies. By contrast recent Organisation for Economic Cooperation & Development (OECD) modelling shows that a permanent increase in UK public investment of 0.5 per cent of GDP could be expected to lead to a long-term increase in GDP of up to 3.5 percentage points, with knock on impacts on tax receipts and public debt. The OBR should examine these issues in its regular reports on the medium and long-term public finances, especially where it is likely that investment may raise debt in the short term but lower it over time.

However, Labour also needs to understand that investment funded by borrowing eventually has its limits. The same OECD paper suggests that the UK could fund higher investment through borrowing for a parliament and still end up with a lower ratio of debt to GDP than would have otherwise been the case. But this will not stay true forever. Funding investment from borrowing for a whole decade would increase the future long-term path of debt. Therefore eventually Labour’s deficit rule will not provide a sufficient constraint for fiscal sustainability. This may not matter in practice however, as it is the party’s debt rule that will actually determine its room for manoeuvre.

Tackling fiscal illusions

The last Labour government was guilty of what the International Monetary Fund (IMF) calls ‘fiscal illusions’ – ie actions to keep liabilities off the public balance sheet in order to reduce headline debt. The most notorious example of this is the public finance initiative and its successors. These schemes were initially conceived to transfer the risk of cost over-runs to contractors but they quickly became a mechanism for postponing the recognition of liabilities to manage public debt. Similarly, Network Rail was deliberately established as a non-profit company to keep it off the balance sheet, despite being effectively controlled by ministers. The company’s shift into the public sector only followed changes to accounting rules to counter these illusions.

These two examples show why exposing ‘fiscal illusions’ is an important issue for Labour. In both cases the possibility of a ‘fiscal illusion’ created incentives for less public delivery and control than would otherwise have been the case. If government accountants and the OBR are required to police and call out these illusions, it is likely to level the playing field in favour of state-delivered solutions.

University funding is a case in point and it lies at the heart of Labour’s plans for power. The post-2012 student loan system is an outstanding example of a fiscal illusion. Coalition ministers turned government grants into loans in order to spare universities from the austerity facing the rest of the public realm. But the loans are an accounting sham that postpone the recognition of public expenditure, allowing spending to take place that does not count towards the deficit today. This is because approaching half the value of student loans will eventually be offset by public subsidies. However these loan write-offs will only count as public spending in the distant future when they eventually take place. As a result the additional costs of Labour’s plan to replace tuition loans with grants will be much lower over the long term than in their first year. The party’s fiscal framework needs to be designed to make sure that this is very clear.

One way to expose fiscal illusions is to make better use of accrual accounting in budgeting because private-sector style accounts record changes to liabilities and assets alongside annual revenue and expenditure. This approach would also force the government to be more upfront about contingent liabilities when making decisions, which might generate more debate about big and risky projects like new nuclear plants or HS2. The 2013 Fabian Society commission on future spending choices discussed the recent development of whole of government accounts (WGA) which seek to create accrual accounts for the whole public sector. The commission said that WGA should be used to inform future budget decisions not just as a ‘rear-view mirror’. Since then there has been little progress on this front and the WGA seem to be little known or used.

Neutrality between tax and spending choices

Finally the presentation and scrutiny of the public finances should be reformed so that policy decisions involving tax and spending choices are treated neutrally. The Public Accounts Committee has been highly critical of the inadequate evaluation of tax reliefs with respect to their costs or policy goals. Comparable spending programmes receive far more attention. HMRC does publish useful data on the costs of what it calls ‘tax expenditures’ but this information is never set beside information on public spending. Parallel tax and spending options with the same end should be evaluated side-by-side.

Tax reliefs and allowances are often used as an alternative to spending to artificially suppress expenditure, which is another form of fiscal illusion. The ONS is tougher on this than it used to be. Under Gordon Brown it classed a large proportion of tax credit spending as a form of tax relief but today it treats so-called ‘tax free childcare’ as a spending programme. Nevertheless, governments of all sides have sought to reduce expenditure as a share of GDP by doing as much as they can through tax reliefs. The most worrying case in recent years has been the ‘spending’ of billions of pounds on raising the income tax personal allowance under the guise of helping low income families. Income transfers have been cut simultaneously and poor working families have been left worse off by the policies combined. This illustrates how public spending is usually more progressive and better targeted than comparable tax reliefs. A pro-state pro-equality Labour government should therefore remove any incentives to choose tax reliefs in place of expenditure. The party has already said it will review all tax reliefs. Next it should go further and create a permanent framework to ensure they are always designed and scrutinised on the same terms as public spending.

This blog is part of our online debate series with ICAEW looking at public finance choices for the left. Read more about the project here.