Two fiscal rules that were followed by Jeremy Hunt as chancellor now stand to be inherited by Rachel Reeves and the Labour government. Simon Wren-Lewis, having first established three criteria, a rational framework by which the worth of any fiscal rule can be assessed, judges one of these existing rules to be good (‘the golden rule’) and the other to be so bad it’s ‘terrible’. What does this mean for the budget?
Keep the golden rule
The golden rule states that in the medium-term day-to-day (i.e. current) government spending should be balanced by the total tax take. Put another way, the current budget should not be in deficit – at least not in benign times.
There are two caveats to this balancing of the budget. Firstly, if the economy is seeking to recover from a recession when interest rates are at or near zero, reflationary deficit spending should be allowed. Secondly, climate change is such a serious issue that Wren-Lewis is inclined to cut the chancellor some slack with regard to revenue spending to combat it.
He would also set a rolling five-year target for achieving balance in the current budget that would allow any chancellor to adjust the budget balance in the interim in response to short-term impacts. It provides a sufficient timeframe to navigate one-off events (e.g. the global financial crisis) and re-set the path back to ‘balance in five years’.
Making a bad rule worse
The second rule, which states that the ratio of debt to GDP should be falling five years hence, Wren-Lewis sees as not merely ‘less than golden’ but, frankly, ‘terrible’. He contends that no serious economist supports this rule, and continues: “…this rule is not fit for any purpose except keeping economic growth down”, since it has the effect of suppressing investment.
It betrays a Micawberish mindset – the Conservative mindset – that debt is bad. Yet all the evidence of the last fourteen years is that the lack of public investment has left the public realm in a terrible state. Compared with the other G7 nations, UK government investment is well below average, and UK economy-wide investment is bumping along the bottom of the rankings.
Abandoning this bad fiscal rule will allow the chancellor to expand public investment to boost economic growth and green the economy. “Getting rid of the falling debt to GDP rule is really a no-brainer for any chancellor whose main concern is the health of the economy rather than what the media commentariat might say.”
The danger of ‘mediamacro’ influence diluting bold policy
One problem facing Labour is from right wing commentators opposed to increases in government borrowing acting as “bond vigilantes” and punishing the chancellor should she try to increase it. They warn darkly of investment strikes in the City, and a potential crisis when the government can no longer sell its debt, a narrative Wren-Lewis unhesitatingly calls “…complete and utter nonsense.” He adds: “Scaremongering works because of an absence of understanding, with most people having little idea of how financial markets work.”
Why should these scare stories be appearing now, when they were not in evidence in advance of the disastrous Truss–Kwarteng budget? Wren-Lewis ascribes this simply to the change to a Labour government, as much of the financial commentariat, based in the City of London, has strong conservative (or possibly Conservative) preferences. The trouble is that too many financial journalists are less than even-handed when they regurgitate this to their readership as a bond-crisis scare story – a prime example of ‘mediamacro’.
More optimistically, President Biden’s successful Inflation Reduction Act in the USA has substantially increased investment “…without creating significant persistent inflationary pressure, and with sensible planning it may be possible to do the same in the UK”.
For Reeves, it is the Office of Budget Responsibility which is “making the reasonable case that additional public investment will almost pay for itself.” So, “all talk of markets going ‘over the edge’ if Reeves increases borrowing to fund that investment is just ludicrous.” A budget that saw an increase in government borrowing might also see a modest rise in interest rates.
Soaking the rich
We have already seen how Wren-Lewis envisaged Labour would have to raise taxes (despite having boxed itself in by promising not to raise certain ones), and how badging these increases as ‘restoring public services’ would be a more positive spin than ‘plugging a fiscal gap’.
However, the restoration of public services to their 2010 (pre-austerity) condition will be a ten-year project, even given a substantial increase in tax revenue. Rachel Reeves is setting a lot of store by economic growth, but Wren-Lewis is sceptical whether this will, by itself, be enough. He writes: “I would have thought anything less than a projected real term increase in departmental spending, after allowing for much more for the NHS, would be politically disastrous for the government.”
Hence it is imperative that revenue from taxation has to increase, and probably by at least £30bn now, rising to £33bn by the end of this parliament. Options identified by Labour so far have been of the ‘small beer’ variety (its four suggestions to date bringing in just £4bn). But there are other options, as Wren-Lewis indicates: “there is clear scope for substantial increases in taxes, even within the limits Labour has imposed on itself (with help from the Conservatives).”
He identifies these areas where the burden of additional taxation falls on the broadest shoulders:
- Employers’ national insurance contributions (£5-12bn).
- Capital gains tax (£14bn if equalised with income tax). Thought by observers of the Labour Party to be a favoured ‘runner’.
- Investment income tax, perhaps incorporating within NIC (£11bn).
- Inheritance tax raise to 45% (£1bn), or a wealth tax of 1% (£13bn).
- Tax threshold freeze extension (£8bn), effectively an income tax rise.
Wren-Lewis believes there is a case for ‘gradualism’, whereby tax changes started this year could be extended in future. He also advocates looking out for any totally new taxes, such as road pricing. (My own suggestion is that the government should look seriously at instituting land value taxation).
Public investment in the UK is woefully low and under the Hunt budget of earlier this year is set to fall from 2.5% of GDP to 1.9% of GDP by 2028/9. This fall needs to be turned into a substantial rise and, as investment, we can justify funding this increase via borrowing. To do this might mean junking the fiscal rule that states that the government debt to GDP ratio needs to be falling by the end of the planning period. To which Wren-Lewis might add ‘good riddance’.
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