October Budget 4 - Good and bad reasons to have fiscal rules, and why bad fiscal rules are worse than having no fiscal rules

 

I was going to write a post about current UK fiscal rules, but judging by comments I get I think I first need to set out why fiscal rules exist in the first place. There seems to be a lot of misunderstanding about why some countries have them and what they are designed to do. So this blog post is a background piece to a later post that will talk about the specific fiscal rules the UK currently has, and what Rachel Reeves should do about them in the Budget.

Let me start with one reason often given for fiscal rules which is just wrong. This says that government debt as a share of GDP is too high, and we need to bring it down. This is not valid because we have no good reason to believe that current levels of debt are too high. After all, from WWI to WWII UK debt to GDP was much higher, and they are much higher in Japan today. The ‘debt is too high’ argument often implicitly assumes that government debt is a bad thing, and as I explain here that is wrong because it appeals to incorrect analogies with household debt. So any fiscal rule (like the current UK 'falling debt to GDP' rule) that presumes lower debt is good is a bad fiscal rule.

However, is there some level of debt to GDP beyond which bad things might happen? A government that borrows in a currency it can create can never be forced to default by the financial markets. However a very high debt level normally involves paying high levels of debt interest, and to do that a government has to raise taxes or cut spending. At some point the political cost of very high taxes or low spending can be so great that the government chooses to default on those interest payments. A more likely option is that the government creates high levels of inflation to devalue that debt. Both outcomes are pretty bad.

The problem with this upper limit to debt to GDP is that it is very hard to work out what it is, because it depends on political choices. What we can say with certainty is that it is much higher than current levels of debt to GDP. That needs to be the case, because often large increases in debt to GDP are absolutely necessary (think of shocks like wars, or major recessions, or pandemics), so governments would always want the ability to raise debt to GDP substantially without risking going past that upper limit. Of course we have little idea when these shocks will happen and how big they will be, so we have little idea how far we need to be away from any upper limit.

While this gives us no guide to what appropriate levels of debt to GDP are, it should make us nervous about forecasts where, because of the current fiscal policy stance (i.e planned tax and spending decisions), debt to GDP is rising inexorably throughout the forecast period and beyond. Economists call this an unsustainable fiscal stance. An example is the US today, which I will come back to. We can say, with a lot of confidence, that dealing with this is something that will have to be solved at some point to ensure sustainability. But is there any reason to believe that it will be better from society’s point of view, or politically easier, to solve it later than solve it now? [1] If not, why not achieve sustainability now?

If sustainability is the goal, this suggests fiscal rules should focus on some measure of the governments deficit, rather than the stock of debt. In addition it is the path of the deficit in the longer term that matters, rather than temporary movements due to economic shocks, or changes to public investment, or temporary changes in spending or taxes. Any fiscal rule that mistakes temporary deficits for a permanently unsustainable path is likely to create bad outcomes. 

 

Why do governments sometims choose to put sustainability at risk? Here we get to the heart of why we have fiscal rules. It is because increasing debt (or bank reserves i.e. creating money) is normally a lot less unpopular than raising taxes or cutting public spending. Generally speaking, voters worry much more about higher taxes or worse public services today than the very uncertain prospect of a future government default. For this reason, politicians who want votes will often be tempted to cut taxes or raise spending by increasing the government’s deficit.

This explains one rather odd feature of fiscal rules. They are commitments governments make themselves to constrain their current and future actions. Why would a government do this if they didn’t have to? The reason is that they know they will face future temptation, particularly as an election draws near, to cut taxes or raise spending (or both) for no other reason than to win votes, and pay for this by increasing the budget deficit. Fiscal rules are their commitment device to stop that happening.

Think of Trump’s tax cuts, for example. Funding these by issuing debt was more popular than cutting spending or raising other taxes, which is why Trump and other Republican politicians did it this way. But by creating a deficit which, at some point, another government might feel they should reduce, Trump was buying popularity at a future government’s expense. It wasn’t a very responsible thing to do, and a system which encourages irresponsible governments isn’t a good system.

Of course that argument is harder to make if we are talking about saving lives by having more doctors rather than cutting taxes paid by the rich. But if the argument for having more doctors is strong, why not ‘pay for them’ with higher taxes rather than a larger deficit? Suggesting that the spending will not happen without deficit finance either suggests that it shouldn’t happen in a democracy, or that we have politicians who are out of touch with what voters want. In reality I think the UK experience suggests balanced budget increases in public spending can be pretty popular.

If you find worrying about unsustainable deficits that might lead at some future date to high inflation or government default too abstract, then there is a more immediate argument for fiscal rules that I set out here. It uses the same idea about governments being tempted to deficit finance to get votes, but the cost is not default at some date in the distant future but higher inflation very shortly. If we start from a position where inflation is stable, then tax cuts or spending increases will lead to inflationary pressure and therefore to central banks raising interest rates.

Why will governments be tempted to do this? Because moderately higher interest rates are often not connected by many voters to tax cuts or spending increases. Central banks rarely say we increased interest rates because of the government’s fiscal actions, which allows governments to deflect blame. Low information voters may therefore credit the government for lower taxes (say) and not punish them for higher interest rates. Again this suggests fiscal rules based on the deficit rather than debt.

It’s a trick that doesn’t always work for governments, as the Truss fiscal event showed. However we know this trick often did work, because of what economists call deficit bias. Government debt in the OECD almost doubled between the mid-70s and mid-90s, for no good macroeconomic reason. Unlike the last two decades, there were no record recessions or pandemics that could explain this increase in debt.

Of course there are some circumstances where deficit finance is appropriate. Public investment that benefits future generations is an example (with the added benefit that this will boost future GDP) or spending in a recession which is essential for Keynesian reasons (where interest rates are unusually low). Often it is responsible to deficit finance and irresponsible not to, which is why fiscal rules have to be more sophisticated than simply always balancing the budget. Anyone in the media who thinks this complexity just represents loopholes for the government shouldn't be commenting on fiscal rules.

Note that, for the UK’s fiscal rules at least, there is a symmetry between spending increases and tax cuts. In that sense, these rules are neutral in terms of the size of the state. In my view that is an important attribute for a good fiscal rule to have.

So fiscal rules are a commitment device for a government that knows it will be tempted to deficit finance to gain votes, which will either add to inflationary pressure in the short term or threaten an unsustainable path for debt in the long term. They will be tempted because a significant proportion of voters don’t see those costs, or do not connect them to the government which uses deficit finance for party political ends.

I started by noting one incorrect reason often given for fiscal rules, which amounted to a presumption that government debt was too high. Let me discuss two other reasons, one of which is simply incorrect and one of which is much more complex than normally suggested.

There is a widespread but incorrect view that fiscal rules are there to reassure financial markets. This motive is hardly ever mentioned in the academic literature on fiscal rules, for a very obvious reason. Fiscal rules are there because governments can exploit low information voters, or voters that are not worried about debt sustainability. By contrast financial markets involve high information actors. They don’t need fiscal rules, or ratings agencies for the major countries for that matter, to tell them about the implications of fiscal decisions.

A second reason often given for fiscal rules is that increasing government debt represents a burden on future generations. I wrote extensively about this a decade ago (see here, for example). This claim is neither unambiguously true or false. One of the odd features of a government living forever is that it can make the current generation better off without penalising any future generation, but only if certain conditions hold and they may not hold.

Getting the reason for fiscal rules right tells us about their importance. Of the many problems in this world, moderately higher interest rates or the cost on future governments of restoring sustainability are not top of the list. This is important when trade-offs between following rules and other issues arise.

The most obvious example is climate change. If action to reduce climate change is prevented by fiscal rules, then the government (or courts) involved have got their priorities very wrong (I would say criminally wrong). Indeed, as fiscal policy designed to promote green energy will only be needed to quickly phase out energy that creates CO2, it will not be permanent and will therefore not threaten sustainabiitty (see also here).

This is also why I often say that a bad fiscal rule is worse than no fiscal rule. A bad fiscal rule could prevent a government enacting fiscal stimulus in a recession, for example. That has consequences that are far worse than allowing the irresponsible behaviour outlined above. A government that failed to enact fiscal stimulus in a recession would be far more irresponsible than one that broke a bad fiscal rule that stopped it from doing so.

The same issue arises in the United States. The US has some really dumb fiscal rules, like the debt ceiling, which are worse than useless and should be thrown away. But equally, the US doesn’t have an overriding deficit type rule like the one we have in the UK, for example. In addition, the US is currently running deficits that do not look sustainable. Would it be a good idea for the US government to impose a sensible fiscal rule that avoided this?

Until recently the US was a good example of where a good fiscal rule would have been helpful. Typically the Republicans gained votes by cutting taxes and running up deficits and the Democrats worried about deficits, tried to bring them down and probably became unpopular as a result. A fiscal rule that stopped the former would have produced better outcomes.

However right now the Republicans under Trump look like they have given up on democracy, and as a result it is essential that they are kept out of power as far as possible within the constraints of a democracy. If the Democrats were forced to follow a fiscal rule that meant higher taxes or less spending, this might harm their electoral chances (see above), and that could end democracy in the US. It is also quite clear that if the Democrats introduced a deficit rule, if the Republicans gained power they would rip it up in order to cut taxes for the better off.

One final point is the mirror image of the last. Many of those who oppose fiscal rules cite 2010 austerity. But the world-wide move to austerity in 2010 had very little to do with fiscal rules, and much more to do with political actors who wanted to shrink the state. That is obvious in the US, where there was no deficit-based fiscal rule, but it was also true in the UK. Labour rightly abandoned its fiscal rule of 10 years standing to enact fiscal expansion in 2009, and the Conservatives chose a rule that enabled them to enact austerity. To suggest that their fiscal rule caused austerity gets cause and effect wrong. Indeed, a sensible fiscal rule like the conditional golden rule proposed by Shadow Chancellor John McDonnell in 2016 might have exposed austerity for the stupidity it was if it had been in effect under the previous Labour government. [2]

Understanding the case for fiscal rules is crucial for any sensible analysis of them. Often criticism of these rules presumes a responsible government, or highly informed voters, assumptions that if they were true would indeed make such rules pointless. Equally often, misunderstanding what these rules are designed to avoid can lead politicians or others to propose or insist on following harmful fiscal rules, with far worse outcomes than if we had no fiscal rules at all.  

[1] In contrast to the US, in the OBR’s 50 year projections for the UK, debt to GDP only increases above current levels around 2040. That is a good reason why political action, although not thought, can be delayed.

[2] The Eurozone is more complex, because what led to the Eurozone crisis spreading beyond Greece was the actions of the central bank. But otherwise I think the points made in relation to the UK also apply there. In particular German politicians and many voters have a phobia about government debt, which leads to the imposition of damaging fiscal rules.

October Budget 3: In presenting a macroeconomic fiscal stance, Rachel Reeves and Labour need to talk about improving public services rather than book balancing

 

Most of this series will be about the economics behind the budget. So far we have had why tax increases rather than economic growth is how to end austerity. Later posts will look at fiscal rules, public investment and what tax rises are possible within the Chancellor’s commitments. This post is more political. It looks at the extent to which Labour can blame tax rises and continuing poor public services on the last government, and how Reeves needs to frame her forthcoming budget.

As is well known, the 2010 Coalition government did a highly effective job in placing the blame for its own spending cuts on the previous Labour government. As a consequence, and incredibly, more voters blamed Labour than the Coalition government for spending cuts. It was incredible given the macroeconomic reality was very different (see here and initial link to my article). Given the reality of the terrible economic record of the 2010-24 Conservative government, it is quite understandable that the current Labour government wants to place the blame for its unpopular decisions on the last government where it can.

A lot of the criticism of this attempt by Labour is based on vibes. It makes Labour seem gloomy, it is argued, whereas what people want is hope and optimism (usually adding references to the Harris campaign in the US). I prefer to think about the different contexts of 2010 and 2024. In 2010 voters were still recovering from the major shock of the Global Financial Crisis, and were seeing the start of the Eurozone crisis, after a previous decade of what looks by today’s standard pretty good times. In contrast, the whole 2010-24 period has been pretty gloomy in terms of real wage growth and public services.

In 2010 there was therefore a single bad economic event that everyone experienced, and it was natural (though wrong) for ‘low information’ voters to blame that on the government in power at the time it happened. With the Eurozone crisis constantly in the news, and seeing it generally portrayed (wrongly in most cases) as a crisis caused by fiscally profligate governments, it was easy for the Coalition government to argue that it too was having to deal with a fiscal crisis caused by the previous profligate government, and easy to suggest it needed austerity to avoid a market crisis like that happening in the Eurozone. As I have noted so many times, most of the media were happy to promote or go along with this narrative.

The clearest example of this Labour government trying to do something similar was Rachel Reeves statement on 29th July, where she talked about how the fiscal situation she inherited is even worse than the OBR had thought, and outlined the cuts she was making as a result. What evidence we have suggests she failed to transfer the blame for this on to the previous government (source and details).

Since the election Labour support has fallen and Conservative support has risen in the polls, such that the Conservatives are just 4% behind in a recent poll. While it must be true that a lot of this is due to the unpopularity of ending the pensioner winter fuel payment [1], this is also a continuation of a trend that began well before the General Election, a point I will come back to later.

So why is Labour not succeeding in transferring blame to the last government when much of that transfer of blame is justified, while in 2010 the Coalition government succeeded in doing so when it wasn’t justified? There is an obvious caveat and also a partial explanation. The caveat is that it is too early to tell. The Coalition’s ‘it is all Labour’s fault’ was a theme pursued relentlessly for years. The partial explanation is that much more of the media will resist that transfer of blame today compared to the period from 2010. It is also possible to argue, as I suggested here, that this transfer of blame might have worked if Reeves had simply reversed recent Conservative tax cuts rather than hitting pensioners, because then the association with past actions would have been clearer.

However I think there is another explanation, which has an important political lesson for the October budget. Even before 2010, the Conservative party managed to convince many voters (again erroneously) that reducing the government budget deficit was the economic problem, and they had considerable support in that from the Labour Chancellor as well as the media. The Eurozone crisis, and the global turn to austerity in 2010, appeared to back them up. So cutting the deficit was what the Coalition were elected to do.

In contrast, this Labour government was not elected to reduce a huge budget deficit. It was elected, in large part, to fix the NHS and other public services. A 'senior Labour source' said recently that Labour were elected 'first and foremost to sort the public finances'. This is nonsense. The election campaign was not about the public finances, as it was in 2010. What the public were concerned about was the NHS. As a result, justifying cuts to fill ‘black holes’ rather than to improve public services was never going to be popular, because that is what the Conservative government did repeatedly and voters wanted a change.

In this respect it is important to ignore what much of the media writes or says. Journalists are obsessed by what they call black holes in the public finances. The term black hole is mediamacro for a gap between a forecast for the government’s deficit and what the government’s chosen fiscal rule says that number should be. [2] This black hole is the slender reed on which to write speculation about what a future budget may contain in the way of tax or spending changes.

Understandably, people tend to care much more about tax increases or spending cuts than black holes. Journalists know this, which is why the ridiculous term black hole is used in the first place. It is designed to transform what is in reality a highly uncertain forecast about budget arithmetic related to something largely artificial into a number that readers should regard as very important and potentially even dangerous. Of course it is neither very important nor dangerous.

Such tricks might get an article read but it doesn’t stop most people thinking poorly of a politician that cuts spending or raises taxes just to fill a black hole, unless there is a general consensus that this black hole threatens a crisis. What the Conservatives did from 2010 onwards, with the help of Labour, the media and the Eurozone crisis, was create that consensus. The consensus today (if you exclude the Conservatives) is that public services need fixing, and not that we are facing a fiscal funding crisis. Attempts by Labour’s Leader of the House to suggest that the financial markets would have reacted badly if Labour had not immediately filled part of the black hole they discovered were met with general and justified derision. Suggestions that cuts were required immediately to fill an unexpectedly high in year deficit are also economic nonsense.

The script for the Budget at the end of October is already being written by the media. Rachel Reeves will increase taxes to fill the part of the black hole she failed to fill in her recent statement. It would be a big mistake if the Chancellor followed this script. As one of the main thing most voters want to see from Labour is an improvement in public services, it would be much better to justify tax rises as enabling additional public spending rather than filling black holes.

What economists call balanced budget increases in public spending, higher spending matched by tax increases, are likely to be popular among most voters when public services are under stress, particularly if those tax increases mainly hit the better off. The 2017 election campaign clearly shows this, and public service provision has deteriorated significantly since then. In contrast, Labour lost votes during the last campaign, in part I suspect because they kept to what Marc Thomas calls their small target strategy, when many voters were looking for something more substantive. They are still looking.

Taxes are bound to rise in October’s budget, and the Conservative opposition will say I told you so. The way to respond to that is not to talk about black holes that Labour inherited, but talk about the woeful state of public services Labour inherited, how Labour are beginning the long process to restore those services, and that this process requires those with broader shoulders to contribute more to enable that to happen. That is what Labour governments are elected to do, and they are popular when they do it.

[1] Why was cutting the winter fuel allowance so unpopular? After all, it is absurd to give wealthy pensioners hundreds of pounds every winter for something they can easily afford. Some of this is just the power of this voting group. But a real problem I suspect is that there is a large group of pensioners whose income is above the level at which they can obtain pension credit, but below a level where it is easy to save in summer months to prepare for higher winter fuel bills, particularly after recent increases in food prices. The UK state pension is low compared to most other countries. I cannot see any reason why the allowance shouldn't be taxed. 

[2] Which in turn is based on a forecast for GDP, as fiscal rules tend to have GDP in the denominator.

October Budget 2: How much do UK taxes need to rise to end public spending austerity?

 

Austerity is a term used in many different ways, but this post will involve numbers, so I need to be precise about what I mean by ending austerity. I want a measure to capture how the provision of public services (including welfare provision) is significantly poorer than people might expect given general levels of prosperity. Note that this definition makes austerity about the level of public services, and not their rate of change. Many people use austerity as shorthand for cuts to public spending, and particularly the period from 2010, but it makes more sense here to treat austerity as reflecting the level of public services relative to some norm defined by general levels of prosperity.

We know we are currently living in a period of public sector austerity by looking at sector specific indicators: hospital waiting times are unusually high, court cases are being delayed for months or years, and so on. (For a detailed analysis covering four key sectors, see this Institute for Government report.) However it is much more difficult to know how much extra spending is required to get all those indicators back to more normal levels.

Some of the spending required to restore public services may be in the form of a one-off increase in public investment, to make up for a lack of investment over the past 14 years. As John Burn-Murdoch showed here for example, investment in the NHS collapsed after 2010. There are excellent reasons why one-off or ‘catch-up’ increases in spending should be financed by borrowing rather than tax increases, while permanent spending increases should be matched by higher taxation. As a result, my focus in this post is on permanent rather than one-off increases in public spending. I will discuss public investment in a later post after talking about fiscal rules.

The aggregate measure I will focus on is public social spending as a share of GDP [1], as defined by the OECD, which I talked about at length in an earlier post. This mainly includes public spending on health and welfare (including state pensions), but excludes education and defence. [2] According to OECD data, UK public social spending was 23.1% of GDP in 2010. I will use this number as a date specific baseline level of public social spending which clearly cannot be described as austerity. It is date specific because this number needs to be updated over time because of trends in health spending.

UK health spending as a share of GDP roughly doubled from 5% to 10% between 1980 and 2010. The reasons why, in order to provide the same level of services, spending on health as a share of GDP needs to rise over time are well known, and include a steadily ageing population. The share of health spending in GDP has also been rising over time in most other countries. It therefore seems reasonable to assume that to maintain 2010 standards of provision, and ignoring the pandemic, this share of health spending in GDP would have needed to increase to around 12% by 2022. In contrast, actual UK health spending as a share of GDP remained pretty flat between 2010 and 2019 (before the pandemic), but the quality of health services clearly deteriorated over that period, as waiting times data shows.

That would imply that austerity free public social spending would have been around 25% of GDP in 2022. OECD data has actual public social spending at 22.1% of GDP in 2022, suggesting a gap of about 3 percentage points of GDP between levels of public spending and what is required to get back to 2010 standards i.e. to ‘end austerity’. UK GDP in 2022 was £2270 billion, so 3% of GDP in 2022 is about £70 billion. If either the GDP share of education or defence (not included in the OECD’s definition of social spending) also needs to rise, then the spending gap will be above 3% of GDP..

Unfortunately the UK’s current position is even worse than this, because the forward plan the current Chancellor has inherited involves austerity getting worse, not better. As was widely discussed during the election (and which was first noted in this blog back in March 2023) the previous Chancellor pencilled in additional cuts to spending over the next five years, to make his tax cuts look affordable. Total current public spending as a share of GDP is set to fall from 44% in 2024/5 to 42.5% in 2028/9. That could mean that 1.5% of GDP of social spending needs to be added to the 3% noted above to end austerity in five years time, giving us 4.5% of GDP’s worth of additional public spending (over £100 billion) required to end austerity.

Perhaps this number can be reduced because Labour can find some areas of wasteful public spending that the previous government was reluctant to cut for ideological reasons. Perhaps additional investment in the public sector, and even public sector pay increases, can improve public sector productivity. But a strong argument can also be made for increasing the share of GDP going to education and defence, which would raise this number. Finally these are, off course, ballpark numbers designed only to give a rough idea of magnitudes required.  

Higher public spending that is temporary, even if temporary means a decade or two in duration, can and generally should be paid for by higher borrowing. However the additional public spending required to end austerity is permanent, and that means it needs to be matched by higher taxes. That in turn implies taxes as a share of GDP need to rise as a share of GDP by a similar amount to public spending [3]

The OBR in their last forecast estimated that taxes as a share of GDP (national accounts definition) will be 37% in the financial year 2028/9. We are frequently told that this share is at record levels, but it is almost never said why this has to be so. As I explained here the trend rise in health spending is bound to mean the share of taxes in GDP keeps rising, because since the end of the ‘peace dividend’ there is no offsetting major area of public spending where spending is steadily declining. We should therefore ignore past UK history as an indicator of what taxes should be. If the Chancellor keeps the current falling debt to GDP rule (see a later post on the fiscal rules on why she shouldn’t) then under the last OBR forecast to get public spending up by 4.5% of GDP would require total taxes to rise to become 41.5% of GDP by 2028/29.

If that seems incredibly high, it is still below the level of taxes as a share of GDP in France, Austria, Finland, Belgium, Italy and Denmark in 2022, and it is likely that a few other European countries will be above 41.5% by 2027. Comparisons with the US, and therefore the whole of the OECD, are meaningless because US taxes don’t pay for universal healthcare.

Of course Reeves is not going to raise taxes on that scale in one budget. However, ending public sector austerity should be a realistic target for Labour to aim for over a ten year period. Labour’s mission on health should involve getting back to how Labour left the health service when it was last in office. If they want ten years in office it makes political sense to raise taxes and spending sooner rather than later. The problem the Chancellor has is that an increase in taxes of the order of magnitude required to end austerity is very hard to achieve while keeping her commitment not to raise income taxes, employees NIC or VAT.

I will look in more detail at what taxes Reeves could raise in a future post. The next post in this series will be about whether some of those tax increases can be avoided by adopting better fiscal rules, on why changing the current rules would be sensible anyway, and how that process should start in October.

[1] The reason I divide public spending by GDP was explained in my first post on the October Budget.

[2] Defining permanent, non-austerity levels of spending in both education and defence is more difficult because the former is influenced by demographic swings, and the latter by medium term but hopefully not long term threats.

[3] Matching tax increases to current and permanent spending increases makes sense over the medium term when output is at a level that ensures inflation is constant, so that what is added to aggregate demand in terms of higher public spending is taken out by higher taxes.