Calling time on fiscal rules

The government’s fiscal rules have moved up the agenda significantly in recent weeks. From the preserve of academics and think tanks, the term now features regularly in newspaper headlines and broadcast bulletins. Meanwhile, the Organisation for Economic Co-operation and Development’s (OECD) has just this week called on the Chancellor to reconsider her fiscal rules and address years of under-investment.

As we address long-term challenges like the green transition, demographic shifts, and future economic shocks, the prevailing framework of these rules — targeting public debt and borrowing — is proving inadequate and it is right that the Chancellor is rethinking these fiscal rules. The challenge now is to replace them with a more flexible, accountable framework.

Britain’s fiscal rules have been based on simplistic targets — ratios like debt-to-GDP and budget balances — that ignore the broader macroeconomic context. One major flaw in the rules is their short-term horizon. The rolling five-year targets typically used by the UK government are too focused on immediate fiscal metrics like deficit reduction and total debt stock.

Ponder this for a moment – the government’s ability to spend today is linked to the forecast of public debt between March 2028 and March 2029. Every subsequent year’s spending is predicated on forecasts that look four to five years ahead. Of the many quirks of our modern financial system, this certainly is up there as the most baffling — where sound spending decisions today are stymied by speculative forecasts.

Successive governments have continuously revised these targets and over the last decade or so, a new set of rules has, on average, lasted for just two years. This uncertainty has led to a lack of confidence and serious underinvestment in critical areas such as infrastructure, green energy, and social care, which have longer-term payoffs. As the OECD has pointed out, the UK needs significant public investment to address its productivity gap, regional disparities and climate commitments.

Decades of fiscal tightening, often to meet these rules, have resulted in cuts to public services, which are now stretched to the limit. The NHS, education, and social care sectors are struggling under the weight of underfunding. This not only damages the life chances of people up and down the country, but also holds back our economy. When we can’t get GP appointments or are unable to get to work then our lives suffer, and we are less productive. Yet the government continues to prioritise deficit reduction over public investment.

These rules have also shown themselves to be inadequate in times of crisis. The government was forced to abandon fiscal targets during the pandemic, highlighting how the current framework forces the government to either abandon its rules in times of crisis and lose credibility or stick to them and make harmful public spending cuts.

The new Chancellor however has indicated some flexibility. At the recent Labour Party Conference, she suggested that it was ​“important we count the benefits of public investment and not just the costs of it” and added that ​“other countries look at assets as well as liabilities, and we’re looking at all of those things.” Whilst this is a welcome signal, we need to seriously consider what a long-term framework for sustainable fiscal policy looks like.

To overcome these challenges, NEF has proposed replacing the current fiscal rules with fiscal referees. This system would be rooted in a more dynamic and adaptive framework, where fiscal decisions are made based on real economic conditions rather than arbitrary numerical targets.

Rather than allowing politicians to set and revise fiscal targets at their convenience, an independent Fiscal Policy Committee (FPC) would be appointed to oversee fiscal policy. This committee could operate out of the Office for Budget Responsibility (OBR) or a similar institution, tasked with estimating an optimal range for the primary balance — considering a broad set of economic indicators like inflation, private sector activity, and resource constraints. The FPC wouldn’t make fiscal decisions directly, but would provide guidelines to the government. If the Chancellor deviates from these recommendations — either by over-borrowing or under-investing — they would be required to explain their reasoning to Parliament. This would introduce a layer of accountability, ensuring fiscal policy is better aligned with long-term economic health.

Alongside our fiscal referees approach, some have proposed a new public sector net worth rule that encourages a shift in focus from simply managing debt to considering the broader value of government assets. This would promote borrowing for productive investments, such as infrastructure and green projects, that can enhance the government’s net worth over time. However, accurately valuing public assets is complex, as many lack market prices and have long-term or intangible benefits. Additionally, these assets are not easily converted to cash when needed, and there’s the potential for political manipulation if governments overstate asset values to justify borrowing. While the rule offers a more comprehensive view of fiscal sustainability, it requires careful oversight and management to be effective.

Complementing this is the green golden rule, which allows the government to borrow specifically for environmentally sustainable projects. This ensures that investments in renewable energy and climate resilience are prioritised, fostering long-term economic and environmental benefits. Allowing public finance institutions and mechanisms like the UK Infrastructure Bank and the National Wealth Fund to borrow off government balance sheets is a ​“no-brainer”. This would remove arbitrary borrowing limits and allow these institutions to make productive, low carbon investments.

The interest rate rule is another that aligns borrowing with prevailing economic conditions, advocating for more borrowing during periods of low interest rates, while tightening fiscal policy when rates rise to prevent unsustainable debt accumulation. Together, these rules present a more flexible and forward-thinking framework for fiscal policy, one that balances the need for responsible borrowing with the imperative to invest in long-term growth and sustainability.

The UK’s fiscal rules are no longer fit for purpose. They are too rigid, too easily manipulated, and too narrowly focused on debt reduction at the expense of long-term investment. Replacing these outdated rules with a more flexible, accountable, and forward-looking framework is critical to prepare the economy for the challenges of the future.

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