Chancellor Reeves urged to change fiscal rules in budget to unlock £57bn #UKFinance

Chancellor Rachel Reeves is being urged to reform the UK’s fiscal framework, with calls to move away from “outdated” fiscal rules and implement changes that would unlock £57bn for investment.

A report from the Institute for Public Policy Research (IPPR) said current rules “fail to promote” fiscal sustainability, choking off valuable investment while also omitting key financial indicators.

Many experts have said the UK’s main target, to have debt as a share of gross domestic product (GDP) falling in five years, is too rigid.

The think tank is calling for a new target for “public sector net worth” (PSNW) instead of relying on the previous government’s approach, which fixated on net public debt. The IPPR said that by focusing on PSNW, the government could increase headroom for borrowing to invest by £57bn.

What is the PSNW?

Under the previous administration, the fiscal rule mandated that net public debt must decline by the fifth year of the economic forecast. The IPPR said that this is a simplistic metric that fails to account for the entirety of the public sector’s financial landscape. The think tank said PSNW, which encompasses all public sector assets and liabilities, provides a more comprehensive view of the government’s fiscal health.

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The shift in focus would allow for a more nuanced understanding of the government’s financial position, similar to how investors assess a company’s worth. Instead of just evaluating debt, a PSNW approach looks at the assets at a government’s disposal, such as public equity stakes and infrastructure, alongside its liabilities, including pension commitments.

The current fiscal rule has not only proven inadequate in promoting fiscal sustainability, according to the IPPR report, but it also overlooks significant factors like debt servicing costs and the long-term returns from public investments.

By neglecting to recognise the potential for borrowing to fund growth-enhancing projects, the UK’s fiscal framework has become a barrier to economic advancement, the think tank argues.

UK investment lagging among G7

The UK currently exhibits the lowest public investment rate among G7 nations. Projections indicate that, under existing plans, public investment could plummet by nearly 30% over the next five years.

The IPPR’s said that adopting a PSNW target could unlock an additional £57bn in borrowing capacity for investment. However, the authors recommend that a portion of this newfound capacity be retained as a buffer against economic uncertainty.

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IPPR proposals

Beyond the immediate fiscal adjustments, the IPPR is urging the government to embark on a broader reform of the UK’s fiscal framework. This would involve key changes such as:

• Rethinking the timeframe of the debt rule to end its sole focus on the difference between years four and five of the economic forecast. This is “unnecessarily narrow”, the report said.

• Putting greater emphasis on debt servicing costs which have little weight under the present system, despite the impact of higher interest rates on the government’s day-to-day spending. Such an indicator is easy for the public to understand and can also reflect the state of the economy.

• Developing metrics that better reflect the future impact of today’s fiscal policy choices such as infrastructure investment versus tax cuts. IPPR highlighted that mainstream institutions such as the International Monetary Fund routinely conduct this type of analysis when assessing countries’ public finances.

• Reflecting the benefits of making the economy more resilient against future shocks such as an energy crisis. This is because reducing future risks to the economy will at the same time improve fiscal sustainability.

Author of the report Carsten Jung, senior economist at IPPR, said: “The UK is stuck in a low growth trap, mainly caused by three decades of ultra-low investment. The new Labour government has been elected on a platform to change this, but has inherited fiscal rules that neither promote growth nor succeed on their own terms in delivering fiscal sustainability.

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“In the short term, the budget should target public sector net worth instead of net debt. This would provide significant additional space to borrow to invest and get the UK building again. But the job won’t be done with this alone. In the long term we need a more wide-ranging framework that covers the cost of our debt but also reflects future economy-wide impacts of today’s fiscal choices.”

Reeves has asked Britons to be prepared for tough decisions in her autumn statement, following the prime minister’s warnings that it would be a “painful budget”.

There has been a lot of speculation around the government’s fiscal rules and their implications for investment, with markets anxious about the potential scale and scope of investment spending that may be financed through borrowing or taxation.

“Ultimately, investment spending will be determined by two things — first, chancellor Reeves’ fiscal rules, and two, Labour’s appetite to boost investment up-front,” Sanjay Raja, chief UK economist at Deutsche Bank, said.

Analysts at the investment bank said they expected to see two core rules guiding the public finances, with Reeves adopting a third “supplementary” rule. They said:

1. Current spending rule: Reeves is expected to adhere to a current budget balance rule, a commitment Labour has already signalled in its manifesto. The key question is how soon Reeves will aim to achieve this balance. Currently, it appears likely that she will target a five-year horizon to balance the budget, though there are indications that this could shift to an earlier target, especially with former chancellor Jeremy Hunt forecasting a potential budget surplus by 2027/28.

2. Debt rule: Reeves has confirmed her intention to reduce the debt-to-GDP ratio by year five of the fiscal forecast. However, uncertainties remain regarding the specific definition of debt-to-GDP. Various suggestions have emerged, including stripping investment from public sector net debt (PSND) or excluding losses from the Asset Purchase Facility (APF). Other proposals include differentiating between public sector net debt and that held by public corporations, such as the National Wealth Fund.

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Deutsche Bank is expecting the chancellor to keep things straightforward by reverting to an aggregate PSND measure, accounting for the Bank of England’s decreasing balance sheet.

“This would take into account the Bank of England’s shrinking balance sheet, giving the chancellor more headroom than the current PSND (ex BoE) rule, while avoiding any market confusion”.

The Deutsche Bank team also believes Reeves will introduce a supplementary rule focused on public sector net worth (PSNW).

“This will, we think, be a supplementary rule — as hinted by Reeves already, with the OBR reporting on both sides of the balance sheet annually, allowing for more transparency on growth and investment projects,” the analysts wrote.

The chancellor will deliver her first autumn budget on 30 October.

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