What’s next for UK fiscal policy?
by Graeme Chamberlin - 20 July 2016
It is often said that ‘rules are made to be broken’, but in the case of the UK’s fiscal rules it is more apt to say ‘rules are made to be abandoned’. It is only a little over a year since the former Chancellor George Osborne unveiled his Charter for Budget Responsibility, but the three pillars on which it was built have crumbled one by one.
The first was the welfare cap, designed to restrict welfare spending below a ceiling set out by the Treasury. This did not last long. The Chancellor’s U-turn on cuts to working tax credits announced in last year’s Spending Review meant the cap was exceeded almost immediately.
The second to go was the target for public sector net debt to fall as a percentage of GDP each year. In light of slowing growth, the former Chancellor admitted in this year’s Spring Budget he was unlikely to meet this target this year.
However, the remaining mandate – to generate a surplus on public sector net borrowing by the end of the fiscal year 2019-20 – was the big one. But even before the Brexit referendum the Treasury was having to make heroic adjustments to the path of government spending and revenues to ensure it was met. As Osborne announced the abandonment of the rule in the wake of the decision to leave the EU, stating the government had to be ‘realistic’ given the likely impact of uncertainty on the economy, there was a sense of the inevitable being brought forward.
So what happens now? The new regime – Prime Minister Theresa May and Chancellor Philip Hammond – have both confirmed the abolition of the rules. They didn’t necessarily have to, as the Fiscal Charter contained a provision for the rules to be suspended should the Office for Budget Responsibility (OBR) forecast economic growth to drop below 1% at any point in the forecast horizon. Most independent forecasters expect this to happen at some point in 2017. There are also no plans for an emergency budget in the aftermath of the vote. It all suggests that the new Tory leadership wants to start with a clean piece of paper at the Autumn Statement. The rhetoric coming out of the Treasury is that this will involve steps to reduce the deficit further, but how and when are up for consideration.
When devising new fiscal rules, the Conservatives might want to consider two of the perfectly sensible suggestions made by the shadow chancellor John McDonnell when outlining his own alternatives to the Fiscal Charter in March. The first would be to reinstate a rule based on a target for the current budget rather than total public sector borrowing, allowing the government more freedom to invest. The Tories know they are vulnerable on public sector investment. In the last five years of the Labour government public investment averaged 2.5% of GDP, under the coalition it fell to 2.2%, and despite Osborne’s protestations, it is forecast at just 1.6% in this parliament.
The second suggestion is a bit more radical – but nonetheless interesting. This would allow a zero lower bound knockout to the fiscal rules – meaning that when interest rates approach zero and the efficacy of monetary policy weakens, fiscal policy can be used to actively support the economy. The extent of the intervention would be decided by the Treasury under advice from the Bank of England. When Gordon Brown introduced his first fiscal rules, the motivation was to ensure that New Labour was seen as credible on the public finances, but also to make it clear the Treasury would be supporting the newly independent Bank of England in its mandate of price stability. Nearly 20 years on, the Bank of England would find its job easier if fiscal policy was doing its share of the work.
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