The role of the OBR

Good morning from New Economy Brief.

The new government outlined their legislative programme with 40 bills in last week’s King's Speech. Among them is the Budget Responsibility Bill which forbids the government from making any “significant and permanent tax and spending changes without an accompanying independent assessment from the Office for Budgetary Responsibility (OBR)”.

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This week’s New Economy Brief explores the role the OBR plays in our political and economic debate, and asks whether a modest tweak to the ‘fiscal lock’ could ensure proper scrutiny of the government's plans in relation to longer-term risks to the public finances from underinvestment and climate change.

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The political history of the OBR.

This is the first major change of governing party the OBR has experienced. It was created early in the 2010 coalition government to make a point that the previous government had overspent and that an external institution was needed to discipline government borrowing through independent and objective scrutiny of the public finances. It was given a strict mandate to assess the effects of the government's tax and spending decisions on debt and deficit levels over the short to medium term. The Treasury had previously done this in-house, often prompting charges that the government was ‘marking its own homework’.

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Labour’s Budget Responsibility Bill. The new bill is also an attempt to accuse the last government of recklessness with the public finances. It will require independent OBR forecasts whenever a policy implies a 1% change in GDP. The suggestion is that Labour will inspire confidence in financial markets, in contrast with Truss’ 2022 mini-budget and its £45bn of unfunded tax cuts with no assessment of the impact on government debt levels.

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Shaping the political debate on fiscal sustainability. The OBR forecasts how each fiscal event’s new policies will affect the government’s ability to meet their fiscal rules – assessed in the short term on a simple pass/fail basis. These assessments are hugely significant in policy-making. Although the public no longer place as much importance on debt and deficit levels as benchmarks of economic success, commentators and the political class still see meeting fiscal rules as an important signal of fiscal responsibility. 

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OBR methodology locks in a cycle of underinvestment and economic stagnation. 

Ben Clift’s new book explains that these judgements have serious economic and political ramifications, despite being “political constructions founded on contestable normative assumptions”. Many economists have criticised the OBR’s methodology for creating a ‘surplus bias’ which (ironically) sacrifices the public finances’ longer-term sustainability in order to signal short term fiscal sustainability to the media and financial markets. Relying on The OBR’s current ‘pass or fail’ judgements for meeting precise (yet highly uncertain) fiscal targets encourage short-termism and distract from more useful commentary about long-term debt sustainability. 

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Self-defeating fiscal contraction. Many economists have criticised the OBR’s approach. NIESR’s Jagjit Chadha thinks it has institutionalised “a deflationary bias in fiscal policy” by encouraging successive Chancellors to tighten fiscal policy to meet arbitrary targets in order to seem ‘fiscally responsible’. Cutting spending to meet short-term targets can paradoxically increase debt-GDP ratios – the economy doesn’t grow, but failing public services mean more spending is needed on crime, healthcare, social security and housing. This means UK government efforts to cut the deficit over the last 15 years have been self-defeating. (For more evidence on the ‘self-defeating’ effects of fiscal contraction, read this paper from Larry Summers: “Attempts to reduce debt via fiscal consolidations have very likely resulted in a higher debt to GDP ratio through their long-term negative impact on output.”)

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Austerity and fiscal multipliers. The OBR persistently underestimates the ability of public investment to create growth. This is partly because its remit focuses on short-term output and debt projections, with a five-year time horizon, and many growth-producing investments (whether in transport infrastructure or education and training) take much longer to pay off. This short-termism goes alongside the low fiscal multiplier the OBR’s models assume, making it underestimate the growth benefits of government spending. Its first assessment in 2010 formed the basis for then-Chancellor George Osborne’s spending cuts, and drew criticism from IMF Chief Economist Olivier Blanchard. The OBR’s low fiscal multiplier had led it to believe that austerity would strengthen the public finances without harming growth much, but Blanchard argued the damage was worse, and fiscal multipliers were usually much larger, than it thought. (We now know that government spending cuts harmed GDP in every advanced economy that tried them.) 

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Modernising the OBR.

The OBR itself is bound by its mandate from the government. It can only assess policy against the government’s own fiscal rules, not offer broader commentary on fiscal sustainability. Economist Nick O’Donovan provides a useful summary of the anti-growth conservative bias of its methodology, but warns that dragging their methodology into a political debate could risk delegitimising it. Instead, he suggests forcing the OBR to assess fiscal sustainability more holistically – this would both improve the OBR's assessments and make it harder for future politicians to run down the public realm under the mantle of fiscal rectitude.

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Long term fiscal risks of a slow transition to net zero. The OBR already undertakes longer-term forecasts to calculate the fiscal risks of events like climate change or an ageing population on the public finances. For instance, its 2021 Fiscal Risks report found that long term debt:GDP ratios could rise to 350 to 400% without action to stop climate change. A slower transition will cost the government and the economy more than acting quickly, through economic disruption, the loss of export potential and more need to import new low-carbon technologies from abroad. If the UK delays progress on its net zero objectives until 2030, GDP would be 3.2% lower by 2050 compared to an ‘early action scenario’. This would follow a period of disruption in which the loss of output relative to this scenario peaks at 6.6% in 2033-34 (towards the end of the government’s planned ‘decade of national renewal’). In the ‘delayed action scenario’, reaching net zero costs the state double, with debt in 2050-51 23% of GDP higher than in the early action scenario. Failing to tackle these risks, for example by investing in decarbonisation, is grossly fiscally irresponsible. 

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A modest change to create fiscal space for the ‘decade of national renewal’... And yet this never comes up in the OBR’s Budget assessments, where its role is limited to assessing individual policies and judging whether the government is passing or failing its self-imposed fiscal rules. This means Chancellors are rarely held to account for underfunding the measures we need to mitigate these “large, and potentially catastrophic, sources of fiscal risks”, in the OBR’s own words. To combat this, Nick O’Donovan suggests that the OBR should integrate their judgements of wider fiscal risks into a new, much broader, fiscal sustainability statement. Similar measures have been supported by the Institute for Government before, where they argue that the Chancellor should be forced to read out the OBR’s statement ahead of their speech. This would hugely improve political debate around Budgets, while making it difficult for Chancellors to put short-term expediency before long-term sustainability.

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 …through an amendment to the Budget Responsibility Bill? Could a simple tweak to the Budget Responsibility Bill greatly improve the role of the OBR in our political and economic discourse? The important lesson from the history of the OBR is that it helps to define the very idea of fiscal sustainability. This relatively small and technocratic change could turn the OBR from an institution that locks in political cycles of austerity, underinvestment and fiscal short-termism, to one that guards against climate-induced fiscal risks, presses for green investment and makes the economy and public finances more resilient. As economist Mariana Mazzucato noted in an interview with Mehreen Khan last week, “the best way to be fiscally responsible is to stimulate the economy”; could this humble change start to reverse 14 years of austerity economics?