Defining public debt

Good morning from New Economy Brief. 

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Speculation is rife about how Chancellor Rachel Reeves might change her fiscal rules ahead of the Budget on October 30th. 

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What options does she have for redefining public debt to create more fiscal space for investment? And could these reforms signal the end of austerity economics? 

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This week’s New Economy Brief looks at various proposals on the table to reform the UK’s fiscal framework.

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Fiscal rule reform likely at Autumn Budget.

The debate about UK fiscal rules has been blown wide open in recent weeks. The Chancellor’s speech to Labour Party conference hinted that “it is time the Treasury moved on from just counting the costs of investments, to recognising the benefits too”. Since then, many of the UK’s top economists, institutions and media commentators have been lining up to propose their favourite new configuration of fiscal rules. Now, many options for reform are on the table and Labour are widely expected to change the definition of public debt to unlock more borrowing for public investment.

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Once again for those at the back: What’s wrong with the current debt rule? The main fiscal rule preventing higher investment at the moment is the Government’s commitment to have debt as a % of GDP falling between the fourth and fifth year of a forecast by the Office for Budget Responsibility. The previous government defined debt as Public Sector Net Debt (excluding the Bank of England’s interventions buying and selling government debt), but that isn’t the only possible definition. We have covered how this rule drives an anti-investment bias in our fiscal policy framework extensively. Essentially, the government assesses the stock of debt as a % of GDP at one point in time (and at such an early point that public investment hasn’t yet had much chance to increase growth), without also judging how the flows of debt and GDP will change over time. This effectively rewards it for cutting investment spending that could increase productivity, growth, tax receipts and thus the sustainability of public debt over the longer term.

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Why change debt definitions? 

During the general election, Rachel Reeves committed to these fiscal rules, but she didn’t specify which measure of debt should be falling. (Labour had also precluded raising more revenue from the main tax levers of VAT, NICs and income tax, which together make up around 75% of all tax revenue.) Redefining how debt is measured under the fiscal rules should allow the government to find extra fiscal space for borrowing to invest. 

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Why borrow to invest? Many economists warned that these fiscal rules have made the UK's public finances less sustainable, not more, as prolonged underinvestment has stifled productivity and growth. For instance, the government inherited plans to cut public sector net investment from 2.4% to 1.8% of GDP by 2028-29 in order to meet this debt rule. New analysis from LSE’s Centre for Economic Transition Expertise (CETEx) shows that cutting investment will jeopardise the government’s mission to achieve the strongest growth in the G7. It shows that, even in a best case scenario, the proposed cuts will reduce GDP by nearly £10bn after five years, rising to over £23bn of lost potential output after ten. (Note that this was calculated using the Office for Budget Responsibility’s (OBR) conservative multipliers, whose methodology was criticised by the National Institute for Economic and Social Research (NIESR) last week, meaning the real impact of the cuts could actually be far worse. Economic stagnation will continue if the government does not change approach and borrow to make sustainable investments. 

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So what reforms could be coming?

But you can measure government debt in many ways, and speculation is rife that Reeves could adopt a different definition from the last government's for the purposes of the fiscal rules. Estimates are starting to appear for how much additional borrowing each option might unlock for investment. One option that CETEx proposes is to exclude the debt generated from the investments made by public finance institutions like the National Wealth Fund (NWF) and GB Energy from the debt rule. Positive Money calculated that this, along with other reforms to make the NWF function like Germany’s public investment bank, should free up £180bn for public investment over the course of the parliament. Another option on the table – one that could coexist with the last – is to free up more headroom by excluding the Bank of England’s losses from selling the bonds it bought during quantitative easing from debt calculations, which could let the government borrow a further £16bn a year.

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Including government assets as well as liabilities. Another interesting suggestion gathering heavyweight support – it’s advocated by the Institute for Public Policy Research (IPPR) and Martin Wolf, and in a joint paper by the Resolution Foundation and OBR head honcho Richard Hughes, among others – is to broaden the definition of debt to include more government assets (such as student loans, guarantees to businesses and more illiquid/non-financial assets like equity stakes in companies or the value of the public transport network and other infrastructure), as well as its liabilities. A new paper from IPPR explains that a Public Sector Net Worth (PSNW) target would give investors a better picture of the government’s true financial position - just as they take a company's assets and growth strategy into account when valuing it, not just its borrowing.

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Time to target Public Sector Net Worth? IPPR calls for swapping the current rule that says debt:GDP must be falling in year five and instead targeting an increase in PSNW at the same point. This could provide an additional £57bn of headroom than it has under the current debt rule. A recent IMF paper notes that fiscal rules based on PSNW are “more conducive to public investment and economic growth, while providing for sensible policy reactions [to changes in financial conditions]”. IPPR’s second-best option is targeting Public Sector Net Financial Liabilities (PSNFL). This would be more incremental and easier to implement, but still permits around £52bn of extra space which could be used for investment. PSNFL leaves out hard-to-value assets like buildings and infrastructure, but it does include financial ones like stakes in companies’ equity held by public sector banks. (For more on PSNW, read our previous New Economy Brief.)

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Is this the end of austerity economics?

As the Resolution Foundation’s recent paper on this topic notes: “the interest should not be solely in which rule ‘allows’ the largest expansion in borrowing. Instead, any changed rule needs to be seen as telling us something about the fiscal priorities of the new Government.” This budget is particularly important as it is the first time Labour have had control of tax and spending decisions in nearly a decade and a half, so they have an opportunity to signal an alternative economic approach 16 weeks after winning the election (and potentially reverse some of the ‘doom and gloom’ headlines since cutting the Winter Fuel Payment). Any change to fiscal rules will signal that the new government appreciates how borrowing to invest contributes to growth, tax receipts, fiscal sustainability and ultimately, a better society. But it might not signal the end of austerity for a few reasons: 

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Will the headroom get spent (and on the right things)? Just because the government can borrow more doesn't mean it will. While some suggest that bond investors would support additional borrowing for investment – see our previous New Economy Brief for more on this – the government may still want to take an incremental approach. Reeves has argued that there isn’t a “race to get money out of the door”. However this needs to be balanced against the clear need for quick action – last week consultancy EY warned of a £700bn ‘investment gap’ by 2040. And some investments really are needed to secure long-term debt sustainability, like increasing resilience to climate change to stop public debt spiralling out of control. (On this, WWF has an interesting proposal – a Net Zero Test to assess whether all spending and tax changes would  help or harm decarbonisation, and to identify investment that’s needed to reach this goal but isn’t currently being made.) 

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A decade of national renewal will take longer than five years. Until we start looking more than five years ahead to assess the public finances, the media will keep fretting over the smallest downturn in forecasted fiscal headroom and putting pressure on politicians to cut spending. This can only harm the government's chances of rebuilding the economy. Last week, economists from Bloomberg and the Financial Times’ editorial board both made proposals to extend the horizon further out. The former say this would account better for the medium-term benefits of both physical and human capital spending, to enable “the government to articulate a clear plan for the public finances in this parliament, with a view to ensuring debt sustainability in the next”. The FT writers want “a more holistic analysis of debt sustainability”, and say the OBR should allow debt to rise over five years if it thinks this would ultimately lead to lower borrowing in the long run. (Neither set of proposals is incompatible with moving to a better debt metric like PSNW.)

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Current spending vs capital. Though the government seems to appreciate the growth benefits of capital investment, day-to-day spending is likely to remain tight – it’s constrained by the government’s other fiscal rule, which states that current spending must be covered by tax receipts. There is a legitimate debate over whether current spending on things that drastically enhance productivity growth in the future (like healthcare and childcare) – could also count as investments. This debate is likely to grow in volume if the new fiscal framework treats current and capital spending very differently.