By: Mike Denham, former chairman of the TaxPayers' Alliance
It’s now been confirmed that the chancellor, Rachel Reeves, will set out new fiscal rules in her forthcoming budget. By reformulating the rules to include public sector assets as well as debt, she hopes to provide more fiscal headroom for infrastructure investment. As she puts it:
“I have been clear as I finalise the budget that it is time that the Treasury moved on from just counting the costs of investments, to recognising the benefits too. Because after 14 years of decline under the Conservatives, we cannot afford not to invest.”
There’s been much discussion of how, by separately identifying borrowing to fund capital investment rather than current spending, such asset inclusive rules could allow the government to borrow more and thereby boost Britain’s infrastructure spending. But what’s been much less discussed is whether the new rules would benefit taxpayers - taxpayers who are already facing the heaviest tax burden since the 1940s and who are likely to be clobbered by further increases in the budget. How do taxpayers benefit from changing the rules?
The existing rule - or “fiscal mandate” as it’s grandly titled - focusses squarely on public sector debt. It requires that one of the various official measures of debt - Public Sector Net Debt (PSND) excluding the Bank of England - should be falling as a percentage of GDP in the final year of the OBR’s rolling five-year forecast. That is the sole element of the mandate, although there are also a few supplementary, non-mandate, targets.
Obviously, a rule that only kicks in five years out is pretty weak, doing little to constrain the growth of debt in the intervening years or its final level. Even so, in the OBR’s forecasts from the March budget, the mandate was delivered by only the narrowest of margins.
The idea of fiscal rules incorporating public sector assets as well as liabilities has been around for some time, and there’s a good economic rationale for it. Borrowing to fund capital investment is in principle very different from borrowing to cover day-to-day spending.
Capital investment is expected to repay its costs over time, and businesses routinely borrow to invest. Banks and other lenders are prepared put up the funds in the knowledge and expectation that those funds will be used to acquire productive assets that will generate future revenue to service the debt. Why should the government be any different?
Well, the government is different because in general the future revenue to service its debt must come from taxpayers. Whether the government is borrowing to invest in infrastructure or to cover day-to-day spending, that basic fact remains. And as was pointed out 200 years ago by banker and economist David Ricardo, government debt is no more or less than deferred taxation. Whatever happens, taxpayers are on the hook.
So, from a taxpayer perspective the important question is whether the additional debt funded infrastructure will generate enough economic growth for the government to service the debt without needing to increase tax rates. If sufficient growth comes through, tax revenues increase without increasing tax rates, so that although taxpayers end up paying more tax in money terms, it’s less as a percentage of their now higher incomes. The tax burden feels lighter.
That’s the theory, and it’s appealing. But how would it play out in practice?
The OBR recently attempted to answer this question, at least in terms of economic growth. Based on a range of international research studies, it estimated that a sustained increase in public investment equivalent to one percentage point of GDP could increase potential output over the long-term by 2.5 per cent. On the OBR’s assumptions, the additional investment generates a positive rate of return both for the economy and the public sector (via higher tax receipts).
At first blush that sounds like it could benefit taxpayers. True, the payoff doesn’t fully materialise for decades, but at least it comes eventually.
Unfortunately, while long-term growth potential might be higher, it’s not at all clear that it would be sufficient to reduce the tax burden.
To begin with, the OBR’s calculations assume that all public investment generates the same average return and uplift to long-term growth. But in reality, public investment covers a wide range of projects, with a correspondingly wide range of prospective returns.
At one end, there’s basic infrastructure, such as roads, railways, and power supplies, with a fairly direct link to long-term growth potential right across the economy. At the other end is social infrastructure, such as hospitals and homes for the elderly where there is a much weaker link. And in between there are a host of other projects with dubious economic payoffs, such as much of the green energy programme. Also, in the recent past around one-quarter of public capital spending hasn’t been direct project investment at all, but capital grants to support private sector entities.
So, the prospective uplift to growth potential depends critically on which specific infrastructure projects are funded. Taxpayers have to trust that the government will somehow pick the right ones.
Unfortunately, our public sector has proved to be poor at picking and delivering economically valuable projects in a cost effective manner.
For one thing, our politicians have shown a persistent weakness for hugely expensive prestige projects over more mundane bread-and-butter investments - HS2 is a classic example, but the tendency goes all the way back to Concorde and earlier.
On top of that, Britain’s cumbersome and expensive planning system loads massive costs onto many projects before they even start. And despite regular attempts to improve things, the public sector still lacks vital skills in contract negotiation and management of private sector suppliers. As a result, cost overruns and delivery delays are standard across virtually all our infrastructure projects.
So, the OBR’s assumptions based on experience around the world might well be too optimistic when applied to this country. Or at least too optimistic absent a radical programme to slash planning restrictions and improve public sector procurement practices.
Another vital issue is whether the bond markets will be prepared to play ball. The government may change its fiscal rules to take account of its assets as well as its debt, but it seems unlikely that will convince the markets to provide more funding at the same rates. Why should they, when the information on government assets is already freely available in the public domain? It won’t be new information.
To put some numbers on it, the March budget projected £660 billion of capital spending over the OBR’s five-year forecast to 2028-29 (equivalent to four to five per cent of GDP in each year). Over the same period Public Sector Net Borrowing (PSNB) was forecast to be £420 billion. So, in cash terms we can say around two-thirds of capital spending was debt financed with the remaining third funded from revenue, mainly tax.
Now suppose this month’s budget redraws the fiscal rules to provide headroom for additional investment. How much more might they want to borrow? We don’t know, but, say, an additional one percent of GDP - as envisaged in the OBR paper - would amount to £150 billion over the forecast period (based on the March budget forecast). Would the markets provide that without demanding higher rates?
Of course, we can’t be sure but given that public sector net debt is already at 100 per cent of GDP and increasing - a situation the IMF has just described as risky - it’s likely that rates would increase, at least somewhat. And that would give a further upward bump to debt interest costs which are already running close to £100 billion a year.
Also, an increase in government borrowing rates would push up the cost of borrowing right across the economy, directly impacting investment in the private sector and tending to reduce it - a process known as crowding out. Indeed, one of the research studies quoted by the OBR looked specifically at this effect and found that over the long-term, additional public investment funded by borrowing crowded out an exact equivalent amount of private investment - that is, there was no long-term uplift in overall GDP.
However, the OBR’s calculations take no account of potentially higher borrowing costs, or crowding out, or a number of other potential negative feedback effects. And in fairness they openly acknowledge that, describing their paper as a discussion document and canvassing outside opinions.
The bottom line is that without radical change to our planning system and public sector capabilities, reformulating the fiscal rules to permit more debt funded public investment is unlikely to reduce our tax burden.
And even if those changes are made - a Big If - the burden would probably still increase in the immediate future. That’s because government borrowing costs have already increased substantially from the ultra-low rates seen during the previous decade, and as explained, the additional borrowing would likely push them still higher. More public debt always increases the debt service bill and that must be paid by taxpayers.
We can all agree that Britain’s infrastructure needs upgrading, but simply changing the fiscal rules to facilitate a public investment surge is likely to increase rather than reduce the tax burden.