In 2022, Liz Truss and Kwasi Kwarteng’s mini-budget – in which £45bn of unfunded tax cuts were announced – sent financial markets into a tailspin and damaged the financial credibility of the UK. In response, the next chancellor, Jeremy Hunt, put fiscal rules in place to restore faith and credibility to foreign investors, the public and other government departments that the British government is able to manage its finances in a sustainable way and there are guardrails in place, albeit self-imposed, to withstand dramatic changes.
What are the fiscal rules and why are they changing?
There are two main rules in place hemming in the new Labour government: ensuring day-to-day spending is matched by tax receipts and reducing debt as a share of GDP in the fifth year of forecast.
National debt has risen considerably, spiking initially after the 2008 financial crash and again during the Covid pandemic. Outstanding debt has now reached 100% of GDP, the highest level since the 1960s.
“If you’re setting a rule where debt must be falling within five years, and debt is very high, then you need a couple of things,” Richard says. “The government needs to ensure the economy is growing so that tax receipts are rising, which helps manage debt by bringing in more money, or it needs to ensure that spending isn’t rising.” With Labour’s commitment to invest in the economy to boost growth and fix public services, spending, to some degree, is necessary, leaving Reeves “in a tight position”, Richard adds.
Jeremy Hunt was barely able to stay within the parameters of his own fiscal rule in the spring, leaving just £8.9bn of headroom. As a result, Reeves is constantly running up against the debt rules.
One way to stop running up against these fiscal rules, while still sticking to them and following through with the pledges of economic growth, is to change the goalposts a little.
How might they change?
Fiscal rules have been ushered in by various governments over the past few decades, often to little effect. Reeves did not want to break Labour’s manifesto commitments and abandon the rules, “but she does want to be a bit clever with them”, Richard says. “She wants to have some wriggle room by changing the definition of debt and measuring it differently.” Reeves is looking at a number of different ways to change how national debt is calculated, thus reducing it and giving her more headroom to invest in projects that would help grow the economy in future.
There are a range of options available to Reeves. The first, and most limited, is to change the definition of debt to exclude losses linked to the Bank of England, which would unlock about £10 to 20bn. Reeves could also target public sector net financial liabilities, which would unlock around £50bn.
The most radical step would be to take into account public sector net worth, which includes all non-financial assets and liabilities like buildings, schools and hospitals, in much the same way a business would record a physical asset on its balance sheet. “That’s quite a logical thing to do, because when the government spends money on an asset, it’s not as though that money just disappears and you don’t get anything in exchange for it,” Richard says. High-cost investments are often designed to last for decades and pay off economically in the long term. This method takes account of the benefits of spending and not just the costs and would add approximately £57bn pounds to Reeves’ headroom. If Reeves did opt to go this way, “it is unlikely that she would use up all of that headroom – she would probably want to keep some in reserve,” Richard adds.
Does this signal a change in the government’s attitude to spending?
Reeves is trying to strike two messages at the same time: tough decisions are still required around tax and day-to-day spending on benefits and service delivery in the NHS, education and policing. But, also, the government is willing to borrow to invest and fund large one-off capital projects, like a new power station, offshore windfarms, road and railways. “Stuff that doesn’t, in theory, have a recurring expense, in the same way that paying the salaries of more than a million NHS workers does,” Richard says. How feasible this balancing act is will become clearer in the weeks to come.
