Sajid Javid must set new fiscal targets to guide tax and spending choices

Fiscal policy is now largely unmoored. This follows a decade in which tax and spending choices have been tightly constrained by successive governments’ clear objective to reduce public borrowing, and it gives the new Chancellor the important task of deciding what new fiscal rules to adopt. This will provide a clear statement of the new Government’s priorities and guide its choices over tax and spending policies.

Existing fiscal rules do little to constrain borrowing or debt beyond 2020/21

Philip Hammond, the former Chancellor, has bequeathed Sajid Javid a set of fiscal rules that provide little guidance on the direction of fiscal policy. There are three rules governing borrowing and debt. The fiscal mandate constrains borrowing only in 2020/21 – to be below 2% of GDP, after adjusting for the ups and downs of the economic cycle. The supplementary target for debt also only provides guidance on the path of debt next year – stating that it must fall as a share of GDP. The third objective – to eliminate borrowing altogether – is far more stringent, and current Government plans are not consistent with achieving this aim. Hammond indicated in March that he might not be wedded to that target, while Boris Johnson never mentioned it during the leadership campaign and focused instead on the ‘headroom’ that is available against the 2020/21 target.

March’s official forecasts suggested that the 2% borrowing target – rather than the debt rule – was a more binding constraint on the Government, and that the head-room against the borrowing target stood at £27 billion. Boris Johnson has suggested that this money could be used to cut taxes, meet his spending priorities, and help the country to cope with a no deal Brexit.

But the March figure assumed the UK would leave the EU in an orderly fashion, with a deal. The Office for Budget Responsibility has shown this head-room could be reduced in the event of no deal –  falling to £23bn in a benign no deal scenario – and, more problematically, that the debt target would be missed altogether.

What happens to public spending after 2020/21?

The bigger question for public services, with no certainty about budgets beyond March next year, is what happens after 2020/21.

If the new Government were to adhere to the currently legislated fiscal target of eliminating borrowing by the middle of the 2020s, then additional spending cuts or tax rises would be needed. If the new Government is not committed to that, then we have no clear idea what will guide their spending commitments beyond March 2021.

How much money does Sajid Javid think the UK government can comfortably borrow each year? How quickly does he want to reduce the country’s public debt? Javid may want to retain some short-term flexibility to use fiscal policy to cushion the economic impact of leaving the EU, particularly if that happens in a disruptive way. But he will still need to answer these questions to determine how much money is available for permanent commitments to public services and benefits – and what the tax system needs to look like to raise the required funds.

Fiscal rules have played a central role since 1997, when Gordon Brown adopted his golden rule – that tax should pay for day-to-day public spending over the course of each economic cycle – to burnish the new Labour Government’s credentials on fiscal prudence. Most other advanced economies also have similar sorts of rules, governing borrowing, debt and/or spending.

Fiscal rules provide a statement of intent

Fiscal rules do not guarantee good fiscal policy. They can incentivise perverse behaviour: for example, the growing use of private finance to fund public investment during the 2000s was partly driven by a desire to keep this expenditure off the balance sheet. They can also be rendered redundant by major economic shocks, as happened during the financial crisis.

Nonetheless, they provide a statement of the Government’s priorities and a signal to investors about the Government’s creditworthiness. Within government they have also been a tool with which chancellors have forced themselves and their colleagues to confront difficult choices: constraints on borrowing and debt mean that extra money for spending increases or tax cuts must usually be met by spending cuts or tax increases elsewhere.

Boris Johnson’s promises to increase spending – on more police officers and schools – and cut taxes could potentially run to tens of billions of pounds a year, and the new Chancellor’s choice of fiscal targets will be an important factor in dictating what money is made available to the new Prime Minister. This will help pave the way for the spending review which is urgently required to address a range of domestic policy challenges.

On winning the Conservative leadership contest, Boris Johnson promised to “ping off the guy ropes of self-doubt and negativity.” For now, however, the guy ropes of fiscal policy are coming loose – with most of the existing fiscal rules doing little to constrain public borrowing or debt beyond next year. Sajid Javid's choice of new fiscal rules – or his failure to set any – will be an important statement of the new Government’s approach to managing the public finances.