Why can’t we do fiscal policy in a grown up way?

 

I suspect to most people what Rachel Reeves announced yesterday went like this. The OBR published a forecast, something it has to do twice a year. Compared to its forecast that went with last year’s October budget, things have got worse, and if Reeves did nothing she would now breach her fiscal rules. As a result she chose to announce cuts to disability benefits which the government estimates will throw at least 250,000 people into poverty.

That is not the full story (see below) but there is enough truth in it to make most people think this is a very odd way to conduct fiscal policy. They would be right. The idea for the title of this post comes from remarks made by Charlie Bean (ex Bank of England, MPC and OBR) at a Resolution Foundation meeting. He notes that Reeves has, wisely according to many, committed to holding just one Budget each year. It follows, he suggests, that what he calls the ‘adult’ response to the OBR’s new forecast would be for Reeves to simply note it, and commit to changing tax and spending plans in the 2025 Budget later this year to ensure the fiscal rules are met.

By October all the spending plans will be settled, and the Chancellor will be considering if and how to change taxes. In a changing world potentially everything will be on the table. Even from a very self-interested political point of view, if she ended up making the same changes to disability benefits as she announced yesterday that announcement will be competing with all the other Budget news and so will have less of a political impact.

So why didn’t she take the adult approach yesterday of just noting the new forecast? The charitable explanation is to blame the Truss debacle, or rather the mistaken lessons that politicians and others have drawn from it. But if that is the case it really is rather silly and juvenile. News about the economy and public finances hits the bond market on a daily basis, and the OBR forecast is just one more item of news. If you have previously announced that you will only make major fiscal decisions once a year, there is no reason at all to think the bond market will react to the OBR forecast in a more significant way than any other piece of public finance news. Nor does cruelty earn you market credibility.

The less charitable answer as to why she didn’t take the adult response of deferring decisions until October is that the Chancellor found it politically convenient to suggest she had been forced to cut disability benefits in order to retain fiscal credibility. If that is the case, then it involves deliberate deception. To see why we need to briefly look at what changed between now and last October.

The OBR’s forecast yesterday incorporated assumptions about public spending across the board, and not just disability payments. Below is a chart of the path in yesterday’s OBR’s forecast of total public sector receipts (‘taxes’) and total public spending excluding net investment (i.e, current expenditure plus depreciation, labelled CE+D) as a share of GDP. Looking at GDP shares has a number of advantages, including abstracting from the main effect of changes in real growth as well as inflation.

The ‘golden’ fiscal rule, which says forecast taxes need to equal planned current spending, means that the two lines need to meet by the end of the forecast period. They do so mostly because of higher taxes, but also because of spending cuts. The share of current spending including depreciation in GDP for 2029/30 is 41.4%, compared to 42.1% in the last completed fiscal year of the previous Conservative government. That in my book is a spending cut, when as I argued in previous posts that increases in spending are desperately needed.

Here are the same chart from the OBR’s budget forecast.

It is the same pattern, but in October both lines ended up above, rather than below, 42% of GDP. What has happened over the last six months is that the forecast for taxes has fallen, so the government has reduced its spending plans to meet its fiscal rule. The government has chosen to respond to lower forecasts for taxes by reducing public spending, rather than increasing some tax rates, and that is a political choice. [1]

Some of the reasons people give for not liking what has happened I think miss the point. Getting the OBR to do the forecast rather than the government is neither here nor there, as any Treasury forecast will reflect similar developments in the public finances. (Been there, seen that.) That fiscal plans are reacting to a very uncertain forecast is unfortunate but how else besides a forecast can you compare spending plans to future taxes? You certainly don’t want to tie current spending to current taxes, but equally allowing future spending to drift apart from expected future taxes makes no economic sense either.

The main reason why it is wrong to react to lower tax forecasts by cutting payments to people with disabilities, and substantially increasing poverty as a result, is because of the political choice it reflects. The Chancellor is not having to make these cuts because otherwise she would not meet her fiscal rules. She is making these cuts because she has chosen to use this method rather than the many others available to her to meet those rules. In particular, she has chosen to increase hardship and poverty for some of the most vulnerable people in society rather than raise taxes on those who can easily afford it. To do this yesterday did not represent an adult and responsible fiscal policy.

[1] This underestimates the squeeze in departmental spending between October and now, because overall spending has been pushed up by higher interest rates on government debt.