The UK government has set itself two fiscal rules. The first is that over the economic cycle it should not borrow to cover current spending. The second is that net debt should not exceed 40% of GDP. The second rule now threatens to curtail investment that is needed – it should be changed.
The first rule (the so-called golden rule) draws a distinction between current spending and capital spending. There are good reasons for drawing that distinction and they are well explained by the Treasury:
“The golden rule promotes fairness between generations: the bill for today’s current spending, which mainly benefits today’s taxpayers, will not be passed onto future generations. In contrast, investment today will benefit taxpayers in future years as well as now. …..The golden rule explicitly recognises the different economic nature of current and capital spending. The Government has a duty to maintain the level of investment required to meet the economy’s needs and to ensure that the public capital stock is kept in good condition. Failure to do so hinders the effective delivery of public services, damages the efficiency of UK business and affects many aspects of our lives”. HM Treasury, “Fiscal Policy: Current and Capital Spending” June 1998
The second rule draws no distinction between borrowing for current spending and borrowing to finance investment. That rule is now coming close to being a binding constraint. Net debt is now around 35% of GDP; the Treasury at the time of the March budget projected it would rise to just over 37% by 2008. If the Office for National Statistics were to include a significantly higher part of capital spending under PFI contracts as net debt (“Debt move narrows Brown’s options”, Financial Times, May 20) – as is both warranted under agreed accounting conventions and is likely – we are close to 40% already.
Because the second rule does not draw a distinction between spending that is likely to enhance the future productive potential of the economy and benefit future generations, and spending that has a higher share of its effects today, it is a dubious basis for a limit on borrowing. In setting that limit at the comparatively low level of 40% it is now likely to become a factor in investment decisions.
But why should we think of 40% as a low level? There are two reasons – one much stronger than the other. The first is that even with a stock of net debt at the 40% limit the UK would have a lower level of debt than most other developed economies. A much stronger reason is that such a limit will imply that if the first fiscal rule is met exactly – so that the government runs a balanced current budget (on average) – then the amount of net investment spending that can be undertaken will probably be lower than is optimal.
The reason is this. Suppose that we start with net debt at 40% of GDP and that the government consistently sets current spending in line with tax revenue so that the current budget is in balance. If we want to keep net debt from rising above 40% of GDP we cannot borrow more, or invest more, than 40% of the increase in GDP. GDP increases by the rate of inflation and the growth of real output. Suppose inflation were 2% (the government’s target for consumer price increases) and real GDP grew by 2.5% (the Treasury’s “prudent” assessment of long-term growth). Then with overall GDP growth of 4.5% the amount of net public sector investment that is allowed cannot exceed 1.8% of GDP (40% of 4.5%). If inflation or real growth in GDP is lower, the amount that can be spent on net public sector investment, assuming a balanced current budget, is even lower.
The government’s anticipated level of net public sector investment in 2005 is around 2.1% of GDP. Net investment as a percent of GDP is planned to rise to 2.3% from next year and stay at that higher level for several years. If it could not exceed 1.8% of GDP then, assuming the government runs a balanced current budget, capital spending would have to be cut by over 20%. To have to cut back on investment when there exists a substantial backlog of required capital spending on schools, hospitals and transport infrastructure, would be extremely unfortunate. Nor can this be side-stepped by use of off-balance sheet financing. There are perfectly sensible reasons to pursue the PFI route to improving infrastructure, but these should have nothing to do with abiding by a 40% debt rule.
So the government should be bold and amend the second of its fiscal rules. There is a case for abolishing the rule completely – relying on the first rule to prevent borrowing being used for current consumption and using the (existing) rule that investment must yield benefits in excess of the cost of capital to get the right level of investment. A less radical move would be increase the net debt ceiling so that it allowed net investment to run at a level closer to the government’s own projections for needed capital spending. Since that level is around 2.3% (over the period to 2010), then with a balanced current budget, 2% inflation and 2.5% real growth, we would need a debt limit of just over 50%.
For the government to change one part of the fiscal framework just after an election so as to allow more borrowing would, inevitably, be jumped on by some as a sign that its economic strategy is in trouble. But the change makes economic sense and is now needed to allow worthwhile investment to be undertaken. Time to be bold.
By David Miles, Morgan Stanley Economist, in Global Economic Foru