Chancellor of the Exchequer Rachel Reeves’ first budget raises questions about whether fresh tax rises will be enough to stabilise the UK’s public finances, while potentially hampering the government’s goal of becoming the fastest growing G7 economy. Amid the debate about tax changes, there is also an important tweak to the fiscal framework to carve out more space for capital expenditure for the long term.
Incorporating long-term thinking into budgets was one of the key recommendations in OMFIF’s latest report, ‘The future of public money’, published in collaboration with EY. The report outlines the need for governments around the world to embrace new fiscal frameworks, evaluation methods and technology to improve the allocation and impact of public spending.
The report was launched at a private roundtable with finance ministries and public finance experts in Washington DC, at the sidelines of the International Monetary Fund-World Bank annual meetings. Speakers at the event discussed the importance of long-term fiscal projections and the range of approaches to fiscal sustainability.
These included Germany’s relatively strict debt brake, which it was argued has incentivised the government to find efficiency gains and create space for additional spending. This contrasts with New Zealand’s more flexible approach, which includes short-term and long-term fiscal objectives over a range of indicators. This involves direct consideration of public sector net worth – a metric that assesses the value of public assets as well as liabilities, therefore providing an incentive for capital expenditure to prevent public asset degradation.
Inching in the right direction
Reeves’ announcements are a step towards the New Zealand approach. The new debt rule defines debt as public sector net financial liabilities, counting ‘not just the liabilities on a government’s balance sheet but the financial assets too’, said the Chancellor in today’s budget speech.
The new fiscal target outlines a fall in net financial liabilities as a share of gross domestic product by 2029-30, rather than in net debt. The result is that there is scope for the government to raise capital spending. The Office for Budget Responsibility projects that ‘estimated average annual real growth in capital spending between 2023-24 and 2028-29 is 2.6 per cent, compared to real annual falls averaging 1.1 per cent in our March forecast’.
However, Reeves’ amendments today appear to adopt a middle-of-the-road approach to long termism. The new rule fails to provide a credible debt anchor in the coming years as public borrowing will rise in the near term, and net financial liabilities will only edge down towards the end of the decade. Equally, the new fiscal rules fail to materially promote capital investment and growth. The new target solely considers net financial liabilities and does not incorporate physical assets.
Accordingly, there remains a lack of incentives for the government to undertake the necessary investment in hospitals, roads and schools, which will degrade in the absence of investment. Moreover, the OBR suggests that the increase in public spending would only boost long-term economic growth ‘if the increased level of public investment were sustained’, suggesting today’s announcement alone will do little to shift the supply-side potential of the economy.
More definitive action is needed
The budget is a start but more needs to be done to ensure UK fiscal policy definitively tackles long-term economic challenges. There remains little information about how the government will address long-term fiscal challenges related to demographics, climate change or asset maintenance. The OMFIF-EY paper advocates factoring such long-term fiscal issues into decision-making.
For instance, incorporating the intertemporal public sector net worth into fiscal frameworks – a step further from the New Zealand or UK approach – would help to bring these long-term factors into the present. Future fiscal costs – including those driven by demographics, climate change or asset maintenance (which are currently modelled by the OBR) – can be directly accounted for in the present day by applying a discount rate. The same can be done for future revenues to assess the long-term impact of potential public investment. The net present value of future expenditure and revenue are then added to existing assets and liabilities to create the overall IPSNW measure.
A 2021 paper by the IMF estimated that, based on 50-year economic projections, the UK IPSNW is minus 249% of GDP. In other words, in the absence of policy changes, UK public sector liabilities will significantly outstrip public assets over the coming decades, mainly due to growing healthcare obligations from an ageing population. The UK is therefore sitting on a fiscal time bomb. Reeves’ tweaks around the margin today are unlikely to alter the picture given that they will neither significantly reduce public debt nor add to public assets or potential growth.
Today’s budget continues to kick the can down the road on long-run fiscal issues in the UK. In the absence of more dramatic changes to the framework to incorporate and tackle issues such as climate change, ageing populations and asset maintenance, the government could be storing up a bigger, potentially more disruptive fiscal adjustment in the years to come.
Nikhil Sanghani is Managing Director, Economic and Monetary Policy Institute, OMFIF.
Download the OMFIF-EY report, ‘The future of public money’.
Image source: UK Treasury