The recent sell off of government bonds in major economies has changed the background to the next UK budget, due on 28 October. But rather than be dominated by global crises, the government should use the opportunity to start major reforms. Chancellor John Healey should combine immediate measures to strengthen the UK fiscal position with decisions aimed at long-term reforms of the taxation and public expenditure.
Attention will be focused on whether and how Healey sticks to the fiscal rules he inherited from his predecessor, given pressures in the bond markets worldwide. The chancellor should strengthen the public finances in ways that do not further complicate fiscal systems and make long-term reform more difficult, particularly as far as the taxation of property and wealth are concerned.
Such a combination of immediate reassurance of the bond markets by early fiscal consolidation combined with long-overdue reforms of the tax and benefit systems is possible, but would take courageous political decisions.
Deficit control and reduction
Recent pressures in government bond markets are not surprising and further sell offs are likely as long as governments of large economies continue year after year with large-scale borrowing. The world’s savings institutions have a duty of caution when investing their clients’ funds and will become increasingly careful about taking on more government debt. Some will reduce their holdings or seek higher returns.
With a lower ratio of accumulated debt-to-gross domestic product than the US, Japan, France and Italy, the UK might have expected to be less vulnerable than these economies and have lower rather than higher yields on its sovereign debt. The fact that in the last two years yields on UK government debt have risen above yields in these economies betrays a lack of trust on the part of markets in UK government policy.
In recent years, chancellors have tended to do the bare minimum to comply with their fiscal rules, which require the current budget to move towards balance and net financial debt to be falling in the Office for Budget Responsibility’s forecasts at the end of the four-year forecast period. Fiscal rectitude has tended to be reached (at least in aspiration) at the last possible moment.
This has typically been achieved by assuming unrealistically low growth of expenditure on public services in the final year, sometimes preceded by increases in expenditure on services – especially the NHS – in the first part of the forecast period. Such behaviour hardly shows a genuine commitment to fiscal tightening. Even a reasonable adjustment to the rule governing public debt increased suspicion that the system of rules was being used to justify as high a level of spending as possible. Such systematic ‘gaming’ of the government’s own fiscal framework reduced trust in the government’s fiscal policy. Following recent bond market development, forecasts for debt interest – already over £100bn each year – are expected to be significantly higher in the next OBR forecast.
Now that crises in the bond markets are a real and present threat, the government should consider a completely different approach. It would be sensible to frontload any fiscal tightening to reassure bond markets. A clear move towards early tightening of UK fiscal policy is unlikely to be emulated by other large sovereign borrowers and could reduce the premium that the UK is paying on its bonds, and thus future debt interest.
How to tighten UK fiscal policy
The government has constrained itself by ruling out large cuts in pension or welfare spending and is wrestling with commitments to raise defence spending. It has a manifesto commitment not to raise the main rates of value added tax, income tax or corporation tax. It has already raised employers’ national insurance contributions and frozen income tax allowances, which means that these options are in practice no longer available to reduce the fiscal deficit. By default, and because to do so would be consistent with its political inclinations, the government will be looking at taxes on property and wealth as well as industries, like banking, that are perceived to be particularly profitable at the moment.
Many of these options are of extremely uncertain yield – particularly in the short term – and would be mercilessly analysed by market operators. The more the forecast yields are open to doubt the more likely that problems in the bond market would intensify. The best course would be for the government to achieve some immediate cuts in public spending (net of any increase in defence spending), and to achieve any further tightening that is needed by raising income tax or VAT.
If it wants its economic policies to be taken seriously by the markets, the government should also set out a detailed programme of fiscal reform that would take more than the rest of this parliament to achieve and could be included in the manifestos of those parties supporting the reforms. The obvious areas to start with would be the pensions triple lock, the benefits system for people not in education, employment or training, and taxation of property where the coexistence of a tax based on property values in the early 1990s with another based on contemporary property values is a national embarrassment.
An early tightening of fiscal policy combined with an ambitious medium-term programme of tax reform might seem a political impossibility. However, given the threat of repeated bond market crises with the UK paying more for its debts than its peers, such a combination of short- and medium-term polices might be the only way through.
Peter Sedgwick was a senior Treasury official, a Vice President of the European Investment Bank 2000-06, Chair of 3i Infrastructure PLC 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.
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Image credit:Â UK Treasury