Iain Begg sets out the history of fiscal rules in the UK and explores the options available to Labour Shadow Chancellor Rachel Reeves should Labour get elected.
If her speech at Labour conference is anything to go by, Rachel Reeves looks intent on burnishing her credentials as the Iron Chancellor who will ensure that her future Cabinet colleagues spurn the temptations of fiscal laxity. In this, there are echoes of Gordon Brown who, in the early years of New Labour, also clamped down on extravagant public spending commitments.
In her speech, Reeves referred explicitly to the ‘iron discipline’ that will characterise her approach to the public finances. She went on to assert that ‘a Labour government will not waiver from iron-clad fiscal rules’.
Chancellors can certainly strengthen their authority by enacting fiscal rules designed to impose transparent limits on the key indicators: usually one, or both of, the public deficit (the gap between government revenue and spending) or the level of public debt (the total amount the government has borrowed). But designing such rules and ensuring they are enforced effectively is difficult.
Perhaps the best-known fiscal rules are those of the EU’s Stability and Growth Pact (SGP), with its two headline benchmarks of a deficit limit of 3% of GDP and debt of 60% of GDP. Critics will, though, immediately point out that the SGP has not exactly been a resounding success – witness the frequency of rule breaches and the succession of sovereign debt crises, starting with Greece in 2009.
In the UK, fiscal rules were introduced in 1997 by Brown, then the Chancellor. His two rules were simple enough. The first was to limit net public debt to 40% of GDP and the second was to borrow only to invest (known as a ‘golden rule’), though averaged over the course of the economic cycle, not enforced year by year.
As an explainer by the Institute for Government sets out, these worked tolerably well up to 2007, although Brown was criticised for stretching the interpretation of the economic cycle to keep (just) within the second rule. Once the global financial crisis struck the rules were suspended, but the coalition government then introduced a new approach, rooted in a Fiscal Responsibility law enacted in 2011.
This law saw the creation of the Office for Budget Responsibility (OBR), charged with providing independent forecasts for the economy and monitoring the public finances. Similar bodies, known as Fiscal Councils, have been established in many countries in the last couple of decades. It also required the government to publish its fiscal rules in a Charter for Budget Responsibility.
The mandate in the current version of the charter is for net public debt to be falling as a proportion of GDP ‘by the fifth year of the rolling forecast period’. There are additional targets: to balance the current budget, also by the fifth year of the rolling forecast period; to constrain net public investment; and to cap welfare expenditure.
However, since 2011 there have been no fewer than eight iterations of these rules. In earlier versions, the current budget was the primary mandate and the target date kept fluctuating. Rules which change so frequently lose their credibility and a blunt assessment is that they are hard to take seriously. They not only have soft long-range targets, but can be changed at the whim of successive Chancellors, undermining their disciplining effect.
The chart below reinforces this assessment. Net public debt when the Charter was introduced in fiscal year 2010/2011 was 70.8% of GDP. Prior to the pandemic it was up to 84.8%, is now hovering around 100% and is not projected to fall below three figures for another two years.
Can Rachel Reeves improve on this record? Her caution on future spending commitments is certainly defensible at a time when public debt is still increasing and higher interest rates risk crowding-out other categories of public spending. But even pared-back spending commitments would still aggravate the fiscal position unless tax increases are envisaged.
This leads to the obvious question of what her fiscal rules will be. In her speech she says she will ‘put forward a new Charter for Budget Responsibility, a new fiscal lock’. Fine, but what will she include in it? If she proposes to achieve the net debt target more quickly, it will mean a tighter squeeze on the public finances in the short-term unless growth miraculously accelerates.
If she opts for a different measure, such as the deficit (as some of the other recent Chancellors have done), can she square it with the many demands for Labour to spend more? Restoring a variation of the New Labour golden rule might make sense, but such a rule is prone to slippage and has lost favour elsewhere for this reason.
Rules and broader fiscal frameworks are never a panacea and can lead to policy choices aimed at meeting the rules rather than responding to economic circumstances. Having ‘escape clauses’ that stipulate when a rule can be over-ridden is wise, so long as it is not abused. But too much flexibility can be a trap.
Moreover, effective fiscal frameworks, as the OECD has shown, require more. Labour would do well to look at arrangements in some of the EU countries with more comprehensive fiscal frameworks in which fiscal rules are but one element. Robust fiscal councils and media scrutiny – which the UK has – reassure markets (as Liz Truss and Kwasi Kwarteng found when they neglected the OBR), but countries with the most enviable public finances are now going noticeably further.
Many also have an expenditure rule which sets a ceiling for the growth of public spending, something directly under the control of the state, unlike either the deficit or the debt. In addition, some (such as the Netherlands) are incorporating medium-term (and sometimes longer) expenditure plans into their fiscal frameworks, while Sweden has made use of a current surplus rule to prepare the public finances for an ageing population. In New Zealand, transparency is central to the approach.
As Bismarck, the original Iron Chancellor, said: “a government must not waver once it has chosen its course. It must not look to the left or right but go forward”.
By Professor Iain Begg, the European Institute, London School of Economics and Political Science.