Last week’s spending cuts were not the fault of the OBR or a medium term golden fiscal rule

 

In my last post I said that Rachel Reeves’s statement last week, and more generally the way fiscal policy has been done since 2010, had nothing to do with the OBR. Many have subsequently questioned this, noting that the OBR was set up in 2010 by George Osborne. When one of the UK’s best journalists suggests that the OBR’s “creation has had unintended consequences and reinforced a short termist, tail chasing psychology to UK economic policy making” you know that these misconceptions about the OBR are widely shared.

Why are they misconceptions? Because the OBR was created to do one key job, and that was the macroeconomic and fiscal forecasting that had previously been done by H.M.Treasury. The Treasury had, by act of parliament, produced a forecast twice a year, so the OBR did as well. The Treasury before 2010 also did a 50 year projection once a year, so the OBR does too. Essentially the Treasury farmed out its macroeconomic forecasting to this new, independent body.

One reason George Osborne liked to give for doing this is his belief that under the previous Labour government Chancellors had leant on Treasury forecasters to produce more favourable forecasts. That may well have happened occasionally (under both Labour and Conservative Chancellors), but it certainly wasn’t routine, for the very good reason that if Chancellors regularly did this Treasury forecasts would lose all credibility. As I showed here, under Gordon Brown Treasury forecasts were at first far too pessimistic about the public finances, and then too optimistic, but it was in 2009 that the Treasury produced forecasts showing massive deficits without policy changes.

So if the OBR had never been created, and the Treasury was still producing its macro forecast, it is almost certain that Osborne's austerity would still have happened, and Reeves would have done exactly what she did last week. Why can I be pretty certain of the latter? Because it was widely known that both growth and tax receipts had been disappointingly poor since the October forecast, and long term interest rates were also higher, so Treasury forecasts were bound to show the deteriorating outlook for tax receipts that I discussed here. If they hadn’t then journalists would have been rightly complaining that Treasury forecasts lacked credibility and that these forecasts should be farmed out to an independent body! [1]

So why is there this misconception about the OBR? [2] The answer is straightforward. The OBR was created at the same time and by the same person who solidified a change in the way UK fiscal policy was done. Before 2010 Chancellors would say that aggregate fiscal policy was about achieving a good macroeconomic performance as well as achieving fiscal rules. From 2010 aggregate fiscal policy became just about hitting fiscal rules. Also important was that Gordon Brown, because of the Treasury’s pessimism noted above, had reduced public debt substantially at the end of the 1990s, so meeting his fiscal rules did not become an issue until the second half of the 2000s.

Osborne thought that by focusing on the deficit he was just following the academic consensus, which said that monetary policy should control short term output and inflation and aggregate fiscal policy should target debt and deficits [3]. His great mistake was not to notice that, both before and certainly following the Global Financial Crisis, macroeconomists were shouting ‘but not when interest rates hit their lower bound’, which they had in 2009. Brown’s government had understood this, which is why fiscal policy was very expansionary in 2009, but it suited Osborne politically to pretend he hadn’t heard or disagreed.

While interest rates remained at their lower bound, fiscal policy should have been directed at achieving a stronger recovery, and debt or deficit targets should have been put to one side. That this didn’t happen is almost certainly partly responsible to some extent for the UK’s poor productivity performance that became evident in the 2010s, and which led to poor growth in real incomes. Since the 2010s productivity growth has declined even further (see here, for example), undoubtedly because of Brexit but also perhaps because of a very badly handled pandemic and continuing austerity.

However, for the last few years interest rates have been well away from their lower bound, so it makes macroeconomic sense to focus aggregate fiscal policy on achieving fiscal rules. Ensuring we have the maximum level of output consistent with stable inflation can be safely left in the hands of monetary policy. Does this mean that any dissatisfaction with what happened last week should be directed at the fiscal rules Reeves has adopted?

Again I think this is mostly wrong, but first let’s be clear what fiscal rules we are talking about. Reeves has two, a ‘falling debt to GDP’ rule and the golden rule, which says spending excluding net investment has to be matched by taxes. The first is economic nonsense, and very damaging nonsense at that, for reasons I outline here. But the rule which is currently binding is the golden rule, so in the remainder of this post I will focus on this.

In my view the golden rule makes a lot of sense. It allows the government to invest as much as it likes, but it says that future taxes should cover planned future current spending. Broadly this rule ensures that government debt stays roughly stable as a share of GDP in the longer term. If we allow future current spending to always be significantly in excess of expected future taxes, the debt to GDP ratio will rise exponentially. That is not sustainable in the long run. [4]

Reeves made two mistakes last week. The first was to think the OBR’s non-budget forecast had to show the fiscal rules being met. As I argued in my last post, a more grown-up fiscal policy would have simply noted the OBR’s forecast, and pledged to take action to meet the fiscal rules in her next Budget. This approach would have been consistent with Reeves’s sensible pledge to hold just one Budget a year, while what she did last week was not. The bond markets would not have collapsed as a result. Her second mistake was to cut spending rather than raise taxes, for reasons examined in detail here, and what is more cutting spending in a particularly cruel way.

Changing fiscal policy just once a year does something to tackle the charge of short-termism highlighted at the beginning of this post. But what about the ‘doom loop’ idea? This is that if growth falters, the deficit increases, leading the Chancellor to cut spending or raise taxes to meet her fiscal rule. But raising taxes or cutting spending reduces output, increasing the deficit, and we get into a downward spiral. If this is what following the golden rule implied, then you could indeed claim that it was helping to depress growth in the longer term.

If interest rates were at or close to their lower bound this would be a real concern, which is why fiscal rules should not apply in these circumstances. But when interest rates are well above their lower bound, as they are now, the doom loop will not operate because tightening fiscal policy will allow monetary policy to stimulate the economy. Crucially, however, monetary policy has to have time to do this, which means that the golden rule should apply to plans and forecasts five years ahead, rather than two or three years ahead. A little noticed mistake that Reeves made in her October budget was to change the golden rule to apply over a three year rather than a five year horizon, which precisely risks creating a doom loop (see the ‘fiscal rules’ section of my post-Budget post here). Needless to say I have seen no analysis in the media about this change, and why it might be harmful.

Why did Reeves make these two mistakes last week, and her mistake in altering the golden rule in October? Of course ministers remain responsible for what they do, but I suspect advice from the Treasury was far from helpful, and that Reeves and her fellow ministers are ill-equipped to depart from Treasury advice. In turn the Treasury may be making poor decisions in part because it has suffered from more than a decade of politicians pursuing poor macroeconomic policy.

I suspect the Treasury would have advised her, incorrectly, that it would be very risky to just note last week’s OBR forecast, with a lot of hand waving and frequent mentions of Truss. It may also have been the Treasury that preferred to listen to the great and the good (including in this case Lords) on fiscal rules without asking those who know rather more about them. This is speculation of course, and I’m happy to hear (in confidence) if I’ve got this wrong. What is clear to me, however, is that last week had nothing to do with the OBR and little to do with the 5 year golden rule, both of which remain valuable bits of the UK’s fiscal framework.

[1] Daniel Susskind argues in the FT that the OBR encourages the Chancellor to adopt policies that the OBR thinks will encourage growth, rather than policies that the Chancellor thinks will encourage growth. I doubt this very much. What the OBR does is look at the evidence in the literature, as it has done with the economic effects of Brexit for example. This is surely a better way to forecast than personal hunches or political wishes. I also doubt very much that the OBR's assessment of this evidence would have much influence on a Chancellor's political agenda.  

[2] Criticism of particular judgements the OBR makes is something completely different. Indeed one of the advantages of the OBR is that it is pretty transparent about the judgements it makes, which allows others to criticise them. 

[3] Of course individual tax measures can be designed to improve productivity. Osborne thought that cutting corporation tax would boost investment. It didn’t.

[4] In the long run we are all dead, so who cares? The simple answer is our children’s children, who will have to deal with a fiscal problem that is much more difficult to solve than it is today.

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.

Labour’s strategic error on tax

 

Two things have become clear to many people since Labour came to government. The first is that the party had done less preparation work for becoming the government than Blair/Brown did in 1997. Given what happened in 2019 its focus was understandably on winning the election. There were important exceptions of course, in the areas of worker’s rights and greening the economy for example. But as the Sue Gray episode, ending the pensioners winter fuel allowance and abolishing NHS England show, a lot more preparation for becoming a government could have been done.

The second is that Labour policy in government, like its policy in opposition, is governed by the need to win elections. In opposition that meant, correctly in my view, embracing policies and rhetoric that appealed to social conservatives rather than social liberals, despite most Labour party members being social liberals. Making Brexit work was the obvious example of that. Perhaps because the party hadn’t prepared as much as they should for government, it has meant continuing that socially conservative stance in government.

That is most obvious in the rhetoric Labour uses on issues like immigration, but it also extends to poverty reduction, foreign aid and welfare. The government has not abolished the two-child limit despite it being a major cause of poverty. Cuts to the welfare budget are also popular with a public who believe (incorrectly) that there is widespread fraud and abuse of the system.

Whether Labour are right that this positioning will help win them the next election as it did the last is unclear. In the last election most social liberals voted Labour or voted tactically because they desperately wanted the Conservatives out of office. Many of these voters will not vote Labour in local elections or byelections, because they don’t like some of the policies the Labour government are implementing. This virtually guarantees Labour will have a torrid time at the polls over the next four years. That doesn’t make a recovery before the next election impossible, particularly if the Conservative/Reform split continues, but it makes victory more uncertain. There is a real danger that being the moderate socially conservative party worked a treat when Labour were in opposition, but it may fail just as spectacularly when Labour are in government.

While that is debatable, Labour’s position on tax is in my view much more obviously damaging to its future prospects. Apparently according to some government sources suggesting Labour raise taxes is ‘unserious’, so what follows is why I think that suggestion is itself unserious, and reflects poor strategic political analysis. My argument is an elaboration of a recent letter to the Financial Times signed by a number of economists, including myself.

Labour ruled out raising most (by revenue) taxes when in opposition, because they feared doing otherwise would lose them the election. They have carried over that belief into government. Despite plenty of opportunities to say that the ‘world has changed’ and to row back on these pledges, Labour have so far kept to them. In addition, in the October budget Rachel Reeves was fairly conservative in raising taxes on unearned income, and she has also ruled out a wealth tax.

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The Conservatives lost the 2024 election, and Labour won, in large part because the country was clearly broken. GDP per head was less than in 2019, and public services were in a critical state. Labour pledged to fix both, and voters will hold them to that pledge. Indeed voters are already doing so, which is why Labour’s electoral honeymoon disappeared so quickly and Reform is doing so well in the polls.

With some justification Labour can argue that it is far too early for voters to judge them on their pledge to get the country working again, but what voters can see and Labour leaders seem in denial about is that the government is not doing nearly enough to get the process of renewal started. On growth, all the last Budget did was end the cuts to public investment the previous government had pencilled in, so public investment will not be an engine of growth. Neither will the planned closer relations with the EU be nearly enough to make a significant difference to growth. Making the planning process for new housing and infrastructure quicker is welcome, but it alone will not get productivity growing again.

On public services, the October budget implied a roughly constant share of spending relative to GDP over five years. As the share of health spending in GDP invariably needs to rise (as it has done in most countries over the last few decades), that means cutting other areas of public spending as a share of GDP over time. Barring miracles, that will not lead to significant improvements in the provision of public services by the time of the next election, and certainly not improvements that voters will notice.

Reform of public services is not an alternative to spending more as a means of renewal. Indeed, successful reform often requires spending more money, while reform done on the cheap can just cause dislocation and a deterioration in service provision.

The UK taxes its citizens far less than comparable countries.

Share of total taxes in GDP in 2022, OECD data

Virtually all our neighbours raise more in taxes than we do. (The only exception is Ireland.) The United States has lower tax, but that is largely because most US citizens pay for health by other means, so comparing our tax rate with the US is illegitimate. [1] Quite simply, if we want as good public services as France, Germany, Spain or Italy, we need to pay more in taxes. This the last Labour government came to understand, but this Labour government seems to have forgotten.

As much of the media is controlled by or made up of people who are relatively wealthy, the argument above is rarely made there. Instead we typically get fed two facts. The first is that taxes in the UK as a share of GDP are close to the OECD average. But the countries with lower taxes than the UK, like the US but also Turkey and Mexico for example, invariably supply much less in public services. The second is that UK taxes are at record high levels. But this is an inevitable consequence of health spending steadily rising as a share of GDP, as it has in most other countries.

I have set out the detailed analysis of why taxes have to rise to get the provision of public services close to the level enjoyed in our European neighbours and that we had at the end of the last Labour government here. It can be summed up with one simple statistic: planned total current public spending in 2029/30 (39.7% of GDP) is slightly below levels recorded in 2022/3 and 2023/4 (40.7% and 39.8% respectively, from OBR data bank). If the government doesn’t think this analysis is serious, perhaps they would like to provide some analysis of their own. I suspect however that the reason the government will not take the argument for higher taxes seriously is far simpler. It is that taxes increased in the last budget, and to increase them any further would be very unpopular, particularly given the cost of living crisis.

There are two fatal flaws in this argument. The first is that much of the tax increase in the last budget were simply reversing the unaffordable tax cuts announced in the last year of the previous government. The second is that crumbling public services are unpopular too, and this government was elected to do something about this. Most voters (unlike much of the media) put improving public services way above cutting taxes as an objective (source), which is why the Conservatives lost so badly.

Another argument used is that it is a mistake to raise taxes during a cost of living crisis. There are two reasons why this argument is wrong. First, there is considerable scope to increase taxes on the well off who are relatively unaffected by higher food and energy prices. There is in my view a strong case for much higher taxes on the very rich and wealthy. Second, for some time earnings have been rising significantly faster than prices, and the need for higher defence spending is a plausible and economically solid reason for breaking earlier tax pledges. Reeves followed Osborne in not raising fuel duty last year, and Stewart Wood calculates that the total cost of freezing fuel duty since 2010 is around £100 billion! As Osborne understood in 2010, higher taxes at the start of a government does not mean electoral disaster at the next election. As an election approaches, of course, it becomes politically harder to raise taxes.

Not raising taxes more in her first budget, and not raising them now, are the major strategic mistakes that Reeves has made. They are far more important than anything involving fiscal rules. [2] These mistakes in turn reflect the absence of any serious analysis of what will be required to allow a noticeable (to voters) improvement in public services before the next election. As a consequence, the best we can probably hope for is that despite this lack of improvement Labour leads the government after the next election, and like the previous Labour government restores the UK’s public services in its second term. Given the critical state of so much of public provision, that delay is both an electoral gamble and very bad for the country.

[1] Partly because of this, the US system for providing health is uniquely inefficient. The only other G7 country that raises slightly less tax than the UK is Canada, and it would be interesting to know why that is.

[2] Although the falling debt to GDP ratio rule is stupid, I suspect it is fears following the Truss debacle and worries about labour shortages that are holding back public investment. Current spending is constrained by the ‘golden rule’, but not wanting to raise taxes is not a good reason to break that rule, and I can see few good reasons to break it right now.