As the Chancellor of the Exchequer Rishi Sunak mulls over the contents of his first Budget, which he will unveil on Wednesday, he should take a pause and think whether this would be a good opportunity to scrap the arbitrary fiscal rules that have governed tax and spending for the last two decades and concentrate on building a framework that can guide us to a better economic future.
That means dropping the ‘budgetarian’ charade of assessing when we will hit a budget balance at some capricious date and define the fundamental objective, targets and instruments of fiscal policy.
A fiscal rule, like the one we have for monetary policy, can be very helpful. If credible, it can ensure that households and firms formulate plans that are consistent with government plans in terms of tax and output consequences. Financial markets will know how much the government will need to raise. Ultimately, some confidence in the capacity of the state to stabilise the economy should support growth.
And yet, unlike their monetary counterpart, we have struggled to define a fiscal rule that is timeless and one that acts to support growth. That the previous Chancellor announced our eighth fiscal rule in the past decade is a sufficient demonstration.
There are some good aspects of the framework. The understanding that a rule will be pursued helps the process of discussions at a departmental level because the overall constraint on expenditure has been publicly stated.
A transparent assessment of whether the rules will be met, but more importantly, alongside a serious assessment of the fiscal plans by an independent body – the Office for Budget Responsibility – is a good innovation, even if it comes at the cost of denuding some of internal Treasury modelling capabilities.
The separation of powers to set fiscal policy and the independent scrutiny seems to be a permanent improvement in macroeconomic management. But the current regime has meant that the focus of the national debate has been distorted from what should fiscal policy be to whether there is any room for a sliver of expenditure one way or the other.
The current fiscal regime is really a mash-up between objectives, target, rules and instruments. Let me compare fiscal to monetary policy.
The key to sustained monetary stability involved an agreement and understanding across society that price stability is the correct long-run objective and it was born of the experience of the 1970s and 1980s. That objective has a numerical target that we can expect policymakers to hit. The rule then explains how the policymaker will respond to the state of the economy by using their instruments to hit their target.
The key to the success of the Bank of England’s inflation target is that we can assign a number to the target of price stability and we understand what the instrument is – Bank Rate – and know that there is a rule operated by the Monetary Policy Committee linking its use to the state of the economy. And although the target might be pursued flexibly with some deviation from time to time so that activity does not become too volatile, anyone formulating plans - whether employer, investor or household - can easily incorporate their beliefs about that target.
Such a discussion is conspicuously absent on fiscal policy. Indeed, there has been more noise about the rules themselves than action. The latest version of the fiscal rules, which were announced almost out of the blue in November 2019, is especially poor. The requirement to balance current spending (excluding investment) by 2023 fails to take account of the current economic circumstances – especially in the wake of the outbreak of the COVID-19 coronavirus.
The upper limit for government borrowing for investment to be no more than 3% of the size of the economy is likely to be end up an incentive to make investment even when it is not required, but worse, an artificial constraint when significant investment is required, as now. And the cap on interest payments as a fraction of revenues is a direct appeal to monetary policy to help.
So what do I suggest? The control of public debt is necessary in order to prioritise current expenditure plans but also to maintain the capacity to deal with an uncertain economic future. The main objective of fiscal policy is to be available to offset or transfer private sector risks.
So the Treasury should lay out a general objective for low and stable public debt in the long run relative to income as the best way of ensuring it can meet current and future socioeconomic risks. The numerical target is probably not timeless and might depend on the view we have on the long-term cost of borrowing, the demands of an ageing society and on whether we want to build up government assets by issuing debt. But we can certainly place a range and a time horizon for public debt under various scenarios.
We then need to explain how the instrument, the current and future primary fiscal surpluses – which is the difference between expenditures and tax receipts excluding interest payments on the national debt – is likely to evolve given economic circumstances and how the path will be revised given any changes in those circumstances.
The path of the primary surplus and the composition of expenditure between current and capital expenditure will, of course, be endogenous to the long-term fiscal objective. Large expenditure shocks, which may arise from dealing with a war or a medical emergency, should generally be financed by gradual increases in taxes and immediate, but strictly temporary, increases in public debt.
The UK has not defaulted on public debt in its modern history and previous episodes of high public indebtedness have been reduced, as a share of GDP, by targeting a series of primary fiscal surpluses (government net borrowing excluding net interest payments) with nominal GDP growth then acting to ensure that the level of public debt is more affordable.
Furthermore, the Chancellor would do well to move away from being solely responsible for setting the fiscal path. Instead responsibility should fall to a Fiscal Council, possibly chaired by the Chancellor, accompanied by independent economic forecasts to set the path of the primary fiscal surplus as a function of expenditure and revenue-raising plans.
Finally, rather than the rather false practice of marking the Chancellor’s homework at every fiscal event, I suggest moving now to a regime in which we learn to think of the path of primary surpluses as a tool that can help fiscal policy meet economic and social objectives. The Chancellor would be able to present this as a new regime designed to offset short-run economic trauma and produce long-run financial stability.
This is a longer version of a 22 February op-ed in the Financial Times.