Rachel Reeves has made welcome changes to the fiscal rules

It is easy to be sceptical of the importance of fiscal rules when they have been changed so frequently by UK chancellors: Rachel Reeves’ latest announcement marks the ninth change of rules in 16 years. But fiscal rules – and, more importantly, the wider fiscal framework that goes with them – are crucial for helping to ensure fiscal sustainability and support good policy making.

There have been clear problems with the fiscal rules and framework in recent years and the government has now made some welcome changes – many of which the Institute for Government has previously called for – which should support better and more stable policy making, as long as the chancellor sticks to her commitments.

Targeting the current budget instead of overall borrowing reduces the incentive to cut investment

Reeves confirmed the Labour manifesto commitment to target current budget balance, rather than Jeremy Hunt’s previous rule targeting borrowing below 3% of GDP. 

Distinguishing between borrowing for investment and borrowing for day-to-day spending, which the current budget rule does (preventing the latter but allowing the former), is a positive step. It reduces the ability for the government, when money is tight, to simply cut investment spending, which people do not notice for many years. This is something many previous governments have done, including the last one.

Moving to three-year debt and borrowing targets will impose more meaningful constraints

For now, the government is targeting current budget balance and debt (as measured by public sector net financial liabilities, PSNFL) falling by the fifth year of the forecast, the same timescale used in Hunt’s rules. But the horizon will gradually shorten over the next two years, so that from 2026/27 onwards the government will target current budget balance and PSNFL three-years ahead.

This is another welcome change. Targets that bind only five years hence provide significant opportunities for government to meet them by simply pencilling in fictitious future tax and spending plans. This has been a major problem in recent years: the last government claimed to be on course to meet its borrowing and debt targets, but this was predicated on the claim that fuel duties would rise significantly from year two onwards and that public service spending would grow very slowly beyond the period for which detailed departmental spending plans had been set out. 

Moving to a three-year target, coupled with the government’s previous announcement that spending reviews will set detailed plans for three years ahead, reduces the scope for this sort of gaming and imposes a tighter constraint on the government’s behaviour. While Reeves has already shown that she may be susceptible to relying on some of the fiscal fictions used by the last government – such as her decision to delay planned increases in fuel duty – rules that bind in three years, rather than five, at least limits the scale of fiction included in the plans.

Targeting a range for the current budget balance should support the ambition to hold only a single fiscal event each year

One additional change the Treasury made, quietly, to its rules was to explicitly target a range for the current budget rather than a single limit. The rule requires that the current budget balance be between -0.5% and +0.5% of GDP. This change, which follows an Institute for Government recommendation, should help to encourage good fiscal policy in two ways. 

First, targeting a range effectively gives the government more flexibility if the forecast deteriorates slightly. This should mean there is less chance that a slight change to the forecast will leave the chancellor on course to breach her fiscal rules and therefore feeling the need to take policy action. This should help support the chancellor’s important commitment to holding only one fiscal event each year, even when the OBR is publishing two fiscal forecasts (one in March and one in the autumn). As the Institute for Government has argued for many years, holding only one fiscal event – which is standard practice in most other countries – should slow down and improve policy making.

Second, the emphasis on a range should make it easier for the chancellor to resist calls to immediately spend any forecast improvement on higher spending or lower taxes. If the forecast improves, but the current budget remains within the target range, a smaller change to fiscal policy is likely. This should make for more strategic policy making and more sustainable public finances.  

The new measure of debt avoids some of the problems with the old one – but creates other risks

One important problem with the measure of debt targeted by previous UK governments (public sector net debt) is that it did not incorporate the value of long-term financial assets held by the government, such as the value of future repayments on loans made by the government to the private sector. This meant that the government could appear to improve public indebtedness by selling off these kinds of long-term assets, even if it did so at below their true market value. This created an incentive for governments to game the rules by, for example, selling the student loan book – as happened in 2017. 

The new target measure, PSNFL, avoids this problem by recognising the value of long-term financial assets. But the margins for potential gaming shift elsewhere. For example, the government will now face a strong incentive to channel money through forms structured as financial assets (which will net off in PSNFL), rather than investing directly in physical assets (which would not). There may be occasions when the former approach makes sense – and is, indeed, the motivation behind the creation of the National Wealth Fund – but sometimes it will not. The government needs to make sure its decisions are not skewed by a focus on the accounting treatment of different approaches. 

The government has promised greater transparency about and scrutiny of the investments it is making. This will be important to deliver to ensure money is being used well.

Reeves has left very little headroom against her fiscal rules

Despite these various improvements to the fiscal rules, Reeves has followed in her predecessor’s footsteps in one way. She has left herself very little headroom against her fiscal rules: just £9.9bn against her most binding rule (current budget balance), compared to Hunt’s £8.9bn against his most binding rule (debt falling). 

This was one of the big gambles she took in her first budget. With little room for manoeuvre against the rules, Reeves may have to revisit her whole plan if the UK’s economic prospects turn out to be worse than this OBR forecast suggest.

Also, by spending most of the extra headroom she gained by switching from targeting public sector net debt excluding the Bank of England’s balance sheet to targeting PSNFL, Reeves has tested investors’ faith that the government can spend this money well on growth-enhancing public investments. It is welcome that the government has announced plans for greater transparency and other guardrails around public investment projects, but it will be important that the detail and practice deliver on the current ambition to ensure money is spent well.

Many of the changes Reeves has made to the fiscal rules and framework should support more stable and sustainable fiscal policy. The key test will be how enduring these commitments prove to be: many other chancellors have also started out with good intentions but subsequently been waylaid.