Rules aren’t made to be token

Fiscal rules are ostensibly tools to reign in chancellors’ worst impulses, keep public spending in check and shore up public trust in the people holding the purse strings. It’s interesting, then, that since they were first introduced to the UK in 1997 all have ultimately been reformulated or abandoned.

Chancellor Alastair Darling found the public finances overcome by events in 2009-10, when a deep recession turned a modest surplus into a yawning deficit. His successor George Osborne struggled to find the spending reductions that would deliver a structural surplus (ie stripping out the effects of the economic cycle) over a rolling 5-year horizon in an environment of slow economic recovery and anaemic tax receipts growth – both at least partly a result of a contractionary fiscal policy. This lead to the date of expected deficit elimination being pushed back from 2014-5 to 2018-9 and then to 2019-20. It remains to be seen whether current Chancellor Philip Hammond will be able to deliver on his promise to deliver a structural deficit no bigger than 2 per cent of GDP by 2020-21.

As the Office for Budget Responsibility (OBR) drily noted in its 2017 Economic and Fiscal Outlook: ‘Since the OBR was established by the Coalition Government in 2010, we have assessed performance against three previous fiscal mandates, three previous supplementary debt targets and two previous welfare caps.’

Crucially, all rules to date have betrayed their designers’ over-optimism about the degree of control policymakers can exert over the public finances, at least in the short term. The budget balance is the difference between money in (primarily tax revenues) and money out (in the form of public spending). Governments have slightly more control over the latter than the former, but both are a function of broader economic conditions – something over which even the most gifted Chancellor has only limited control despite what they might like to believe.

Notwithstanding the difficulty we have had in keeping to them thus far, fiscal rules undoubtedly serve a useful purpose as a tool for fiscal management. They aid transparency, and, along with the supporting analysis from the OBR, help the Opposition and external commentators to hold the government to account in a way that was much more difficult to do before they existed.

So, how to create rules where failure isn’t inevitable? It boils down to three features that fiscal rules need to exhibit: they need to be flexible enough to allow for the public finances to absorb the impacts of a recessionary period; nuanced enough that they permit spending on measures that will enhance our economic wellbeing over the long term; and restrictive enough to be a meaningful tool for moderating Chancellors’ behaviour.

This moderation needs to go in both directions. Recent governments have displayed what could be characterised as a ‘surplus bias’ where chancellors favour running a surplus even where there is no economic justification for doing so. It is as important to guard against this form of bias as it is to prevent ‘deficit bias’: the tendency Chancellors have had in the past to overspend.

IPPR proposes three new fiscal rules that would provide the right balance between precision and flexibility within a framework designed to mitigate against both deficit bias and surplus bias.

First, we think that Chancellors should be aiming for a balanced current budget (ie excluding investment spending) over a forward looking, rolling five-year window. Rather than trying to determine how much of a deficit is ‘structural’ and how much ‘cyclical’, we think the crucial distinction is between spending on day-to-day costs such as public sector wages, and spending to invest in long-term projects that will ultimately deliver a social and/or economic return. It makes sense to take investment out of the deficit target – it has very different implications for the sustainability of the public finances, and given that it benefits current and future generations, the up-front cost should be shared across both. Aiming for balance over a five-year rolling horizon means there is the space to respond if the economy should suffer a downturn, rather than being tied to an arbitrary future date.

Second, we think government debt should be targeted over a rolling five-year horizon. Specific, inflexible targets for the level of government debt as a percentage of GDP don’t really make economic sense, as the sustainable level of debt changes over time. It depends on two things: the maturity profile of the debt (when the government has to pay or renew its debts), and the difference between the debt interest rate and tax receipts growth. If the rate of receipts growth is higher than the interest rate, the debt is sustainable. We therefore believe the task of setting the sustainable level of debt for each five-year period should be delegated to technocrats, and suggest passing it to the OBR.

Finally, we think investment needs a boost through the fiscal framework. The UK’s problem is not that the government would be tempted to over-invest; it’s that – as a country – we don’t invest enough. Therefore, we propose the government introduce a third rule that sets a target for a minimum level of investment spending by the government, again over a rolling five-year period.

These three rules taken together would ensure day-to-day spending was affordable while avoiding arbitrary deadlines for achieving a balanced budget; provide markets with the assurance that debt is manageable over the long-term; and ensure that the public sector invests sufficiently for the country’s future.