A new set of fiscal rules
The scale of the fiscal challenge ahead may require some fresh thinking on how to aid the economic recovery, and a new perspective on what constitutes sustainable public finances in an era of low interest rates. Most importantly, the next generation of fiscal rules will need to allow for sufficient flexibility to address the public health crisis and expected economic downturn, while also setting a longer term path for the public finances.
Indeed, an increasing number of economists appear to agree that reducing the deficit should not be the priority in the upcoming UK Budget, with 63% of economists in a recent survey stating that fiscal consolidation should wait until the effects of the pandemic subside. This assessment is also shared by the IFS: "Given the low cost of borrowing – due to extremely low effective interest rates on government borrowing – further borrowing in 2020–21 which led to a stronger subsequent economic recovery would most likely be worth doing. And it also means that any new policy action that is taken to reduce borrowing need not – and indeed should not – be implemented until the economy is back to a more normal performance."
There is also some evidence that implementing fiscal consolidation before the economic recovery is well underway may harm economic output and employment. In this section, we therefore make the case for a more flexible set of fiscal rules that prioritises economic stimulus over deficit reduction in times of crisis, and provides a more comprehensive assessment of the Government's balance sheet once the economic recovery has taken hold.
Why fiscal rules matter
There are a number of benefits from following fiscal rules. Well-designed fiscal targets provide helpful discipline to government spending decisions, anchor firms' and households' expectations by adding transparency to the government's intentions and signal commitment to return the public finances to health, thus lowering borrowing costs. Over the past two decades, the UK's fiscal rules have been designed either to strengthen fiscal prudence in a period of economic expansion (1998-2008) or to return the public finances to health following the financial crisis (2008-2020).
However, while their general benefits are widely acknowledged, now may not be the time to follow traditional fiscal rules. As the UK emerges from the greatest economic shock of our lifetime, it is essential that fiscal rules do not constrain the fiscal policy response, thereby weakening the economic recovery and doing more harm to the long term fiscal position.
Our proposal: Avoid a return to the austerity of the past by adopting flexible fiscal rules
We propose setting a longer-term fiscal anchor, while temporarily suspending the fiscal targets until the economy has recovered. Previous fiscal rules have done this by targeting deficit estimates that accounted for the ups and downs of the economic cycle. As a simple alternative, an escape clause could be introduced into the framework which would see some, but not all, of the fiscal rules suspended for a limited period of time and linked to a measurable set of criteria. Once the economic recovery has taken hold, the rules would be reinstated and the deadline for meeting them reset. To ensure fiscal prudence, the OBR would play an important role as the independent fiscal watchdog in assessing whether the criteria for suspension and reinstatement have been met.
In its 2015 Charter for Budget Responsibility, the UK Government adopted a similar approach, stating that its fiscal mandate would only apply if the OBR were to confirm that the UK economy is not expected to experience a negative shock, defined by the Government as real GDP growth of less than 1 per cent on a rolling 4 quarter on 4 quarter basis. Such an approach is easily understood and could be adopted again. The latest Charter also includes an escape clause in the event of a "significant" economic shock, without providing a measurable threshold, leaving it to the Treasury's discretion to decide whether the fiscal rules are appropriate or not.
Escape clauses are also used by a number of other countries, including Germany, Spain, and Switzerland. For example, in Germany fiscal rules can be suspended in the event of a natural disaster or an unusual emergency situation outside government control, subject to parliamentary approval and as long as a recovery plan is presented. This approach provides flexibility in managing the public finances in times of true crisis.
The UK Government's current fiscal rules
The UK's current legislated fiscal rules require the structural deficit to lie below 2% of GDP by 2020-21 and debt, as a share of GDP, to fall in the same year. However, the 2019 Conservative election manifesto set out a new set of relatively looser fiscal targets which guided the Chancellor's decisions in the (pre-COVID-19) March 2020 Budget:
- 1. Balance the current budget by the third year of a rolling five year period (2022-23), meaning that all spending on day to day public services would be entirely funded from tax revenues. This is similar to the fiscal rules adopted by Labour (1997 to 2008) and the Coalition Government (2010 to 2015);
- 2. Ensure that net investment does not exceed 3% of GDP on average over the rolling 5 year period. Taken together with the first target, this essentially puts a 3% ceiling on the fiscal deficit;
- 3. If the debt-interest-to-revenue ratio is forecast to remain over 6% for a sustained period, the Government will act to ensure the debt-to-GDP ratio is falling. This approach ensures that the overall debt burden remains sustainable by taking account not only of the volume of the national debt, but also its cost and the government's ability to service it.
It is currently unclear if the UK Government is planning on including an escape clause into this framework.
Current Fiscal Headroom
Even prior to the pandemic, and its adverse effect on the public finances, the Chancellor had very little headroom against his proposed fiscal targets. According to the OBR's (pre-COVID-19) March 2020 forecast, he was on course to meet the current budget balance target in 2022-23, with only £12 billion to spare. It is highly likely that this headroom will be eroded further even in the best case scenario of a V-shaped economic recovery. Following significant increases in capital spend announced at Budget, the UK Government also has virtually no headroom against its investment target.
As long as interest rates remain at their current record lows, the debt interest to revenue ratio requirement is unlikely to restrict the Government's room for manoeuvre in the near future. While the UK Government has so far not encountered any problems in funding the significant fiscal interventions, there is a risk that the costs of servicing the countries' debt may rise in the future.
Chart 5 Description
A chart showing the debt interest to revenue ratio, from 1946 to 2024. The ratio has been consistently above 6% of GDP until the early 2000, except for one year. Since then, it has remained below 6% of GDP except for 2 years, and is projected to remain under this threshold until 2024.
Most importantly, a high debt interest to revenue ratio does not necessarily mean that debt levels will remain high, nor does a low ratio result in falling debt. As illustrated in Chart 5, this ratio exceeded 6% until 1991-92. This was due to higher nominal interest rates as well as high levels of post-war debt, but the overall debt to GDP ratio fell through most of this period. At the same time, with the exception of two years, the ratio has been below 6% since the financial crisis, despite debt increasing significantly over this period. The significant additional borrowing pencilled in for 2020-21 will make little difference to the ratio, on the OBR's calculations. These considerations are, however, important for the overall management of the country's debt which now stands at £1.8 trillion. Much of the existing debt stock was raised at interest rates that were much higher than the current rates. There may therefore be a case for refinancing existing debt in order to free up further resources for public spending in the short and longer term.
It is clear, therefore, that the UK Government's current, and proposed, fiscal rules are not designed for, or able to support, recovery from this crisis
Our Proposal: Recognise the value of investment by assessing the government's fiscal sustainability in terms of its public sector net worth
While the immediate focus of fiscal policy should be to aid the economic recovery, the UK Government should also review its current, and proposed, fiscal rules to ensure they are still fit for purpose in a world where the government may need to intervene, and potentially invest, in certain sectors of the economy that are unlikely to resume economic activity soon. Setting medium term fiscal targets now would signal a commitment to repair the public finances in the longer term and anchor people's expectations.
One option, also advocated by the Resolution Foundation, is to shift the focus from the narrow definition of public sector net debt to the wider government balance sheet, with a view to capture the full benefits and costs of government interventions in the economy. This would bring the reporting of the public finances in line with accounting practices used internationally by the private sector. HM Treasury also acknowledged the potential benefits of this approach: "Taking a more comprehensive view of the government balance sheet can help to provide a more complete picture of the sustainability of the public finances and promote greater accountability for the management of public wealth".
Targeting improvements in public sector net worth (PSNW), rather than public sector debt, would come with clear advantages. PSNW covers all financial and non-financial assets and liabilities (see Annex A). This approach therefore supports borrowing for growth-enhancing investment while also capturing the increasing importance of financial transactions, such as asset purchases and bank nationalisations. These were a key element in bringing the risk onto the government's balance sheet during the financial crisis and similar measures may well have to be adopted to support strategically important businesses – under the Treasury's Project Birch scheme – and industries through the current crisis. Loans, guarantees, and other financial instruments would likewise be captured under this measure. It also encourages governments to manage assets and liabilities responsibly, and for the benefit of future generations, while accounting for the costs of an ageing population. Finally, a strong balance sheet may reduce borrowing costs.
Recent improvements in public sector balance sheet reporting, such as the publication of more frequent and timely data through the ONS, make this approach practically feasible for the first time. In addition, the OBR also forecasts the evolution of the Government's financial balance sheet (see Annex). However, the Institute for Fiscal Studies (IFS) voiced some caution about this approach: "Keeping an eye on public sector net worth certainly makes sense. Targeting it as the key element of your fiscal framework may lack the sort of transparency and credibility required of such a framework. It would need to be combined with a commitment to ensure that policy was consistent with public sector net debt being on a decisively downwards path over the longer term (rather than over a parliament)." This reflects the fact that public sector debt and borrowing remain important internationally comparable measures.
In conclusion, we therefore propose adding two additional fiscal rules to the UK Government's (pre-COVID-19) fiscal targets:
- An escape clause which retains sufficient flexibility to allow for further fiscal stimulus in times of significant economic disruption, based on a set of criteria and assessed by the independent OBR;
- A net worth objective which would seek to improve public sector net worth over the next five years as a different measure of fiscal sustainability.
Our Proposal: Enable Scotland to shape its own response to the pandemic by providing further consequentials for investment into the Scottish economy and by extending Scotland's fiscal flexibilities.
The Scottish Government has also taken a series of unprecedented policy actions with significant fiscal implications in response to the crisis: this included £780 million of additional funding in respect of Health and Social Care, £2.3 billion of business support measures as well as a £350 million community support package for those most affected by the pandemic. The Scottish Government has also announced a £230 million investment package to help stimulate Scotland's economy following the pandemic, covering construction, low carbon, digitisation, and business support.
The financial assistance has been targeted to reflect the differences between Scotland's economy and recovery and the rest of the UK, providing additional assistance to groups such as fishermen and small B&Bs. Some of the groups that have been unable to access the UK Government's schemes have also been supported by the Scottish Government's extra funds, such as the £185 million fund to support the recently self-employed and SMEs.
However, Scotland's ability to shape its own response to the pandemic and economic recovery is limited by the fact that a large proportion of the Scottish Budget is still determined by the block grant received from the UK Government via the Barnett formula. In addition, the Scottish Government has virtually no borrowing powers to support additional spending on day-to-day public services. Scotland's capital borrowing powers for growth-enhancing investment are also limited and capped at £450 million per year (0.3% of GDP) and £3 billion in total. This means that the UK Government's block grant is the only significant source of extra funding during the pandemic. This restricts our ability to effectively plan our response as our funding position is not clear until the UK Government has finalised its own funding decisions which might be too late.
Through the operation of the fiscal framework, the relative performance of tax receipts and social security expenditure in Scotland compared to the rest of the UK also plays an important part in determining the Scottish Government's budget. One of the key principles of the fiscal framework is that the UK government should continue to manage risks and economic shocks that affect the whole of the UK. The fiscal framework therefore protects Scotland against UK‑wide and symmetric economic shocks, as the fall in receipts would be broadly mirrored by an equivalent fall in the Block Grant Adjustment, as revenues will also decline in the rest of the UK. Welfare spending is similarly affected. However, it offers no protection should the COVID-19 impact be worse in Scotland than in other parts of the UK, either in terms of health impacts or because of differences in the underlying structure of the economy.
It is becoming increasingly clear that the flexibilities within the fiscal framework are not sufficient to cope with either the fiscal risk of the pandemic, or the demands of rebuilding the economy in future years. This view is also shared by a range of commentators, including the Institute for Fiscal Studies and the Fraser of Allander Institute. This is why the Scottish Government is asking the UK Government for additional flexibilities to ensure that the risks faced by the Scottish Parliament are commensurate with its powers to manage them. Our focus now must not only be on the immediate response, but also on the powers needed to rebuild our economy in the coming years. With interest rates at historic lows, we also propose to reconsider the effectiveness of the current capital borrowing limits and re-examine the merits of a prudential borrowing regime, as recommended by the Smith Commission, to allow the Scottish Government to borrow to invest.