By Linda Yueh
The Autumn Statement is the first indication of where the new U.K. government is headed in terms of fiscal policy. It’s a tricky course to navigate as the Chancellor Philip Hammond maneuvers between the Prime Minister’s wish to help JAMs (just about managing) families (which means looser fiscal policy) and showing an ability to bring down the level of government debt which is now expected to peak at over 90% of GDP (and means continued tightening of fiscal policy).
The Chancellor’s solution is to adopt a new "fiscal mandate," which is a looser set of rules around government spending with targets that don’t need to be met until the next Parliament. Since the previous fiscal rules were missed, there is an argument over whether any such rules are credible. Nevertheless, the Chancellor has put forward new ones, but they run some of the same risks as the last set. In fact, the Institute of Fiscal Studies (IFS) finds that 10 of 12 fiscal rules in the past couple of decades have been breached.
In any case, the Chancellor believes the British government has to give guidance about where fiscal policy is headed, so there are now three new fiscal rules which mirror the old ones but are looser. Firstly, the welfare cap remains but won’t apply until the next Parliament. Secondly, public debt now has to fall as a share of GDP not every year but by the next Parliament.
The most significant change is how the budget deficit is measured. The target is for the cyclically-adjusted fiscal deficit to fall below 2% of GDP in 2021-22, so also in the next Parliament. "Cyclically adjusted" means the government is targeting the structural deficit, which is the part of the budget deficit that is not due to the ups and downs of the economy. As an example, the independent Office for Budget Responsibility (OBR) estimates that the overall budget deficit is 4% of GDP at present, but the structural deficit is 3.8% of GDP. Of course, it is tricky to measure which parts of the deficit is “structural” and which are “cyclical” in economic terms. It’s a similar challenge as measuring the potential growth rate and the output gap of the economy.
A similar target would have been to aim for a primary surplus, so a budget surplus and not counting debt interest payments. Interest payments are not part of current government spending, so the primary budget position is used as a gauge of government spending and revenues in other countries to assess fiscal sustainability. A primary surplus target would have been harder to meet since the surplus or deficit includes cyclical as well as structural elements, but it is easier to measure and offers clarity. By the same token, it would have left less scope for borrowing if the economy stumbles, and the Chancellor mentioned several times that the effects of Brexit are to create uncertainty about the future so he wanted “fiscal headroom” to raise spending in case of a downturn.
So, over the remaining course of the Parliament, the new fiscal deficit target gives the Chancellor more room for spending on JAMs, for instance. The OBR estimates this fiscal rule gives the government scope for nearly 2.5% of GDP (£56 billion) more structural borrowing in 2020-21.
But, the OBR finds that downgraded economic growth forecasts have already taken away 0.9% of GDP (£20 billion) of that additional fiscal space.
Notably, the Chancellor has said that he will borrow to invest and fund innovation, which are both areas that require funding to support economic growth. He has committed to spend 0.4% of GDP (£9.5 billion), mostly in infrastructure spending but also with some measures for JAMs including raising the National Living Wage and revising the Universal Credit.
It still leaves 1.2% of GDP (£26.5 billion) of scope for borrowing by the government in case the economy weakens. In other words, if the potential negative impact of Brexit is worse than the OBR estimates, which is to reduce the size of the economy by 2.4% over the Parliament, then the government can raise spending and still meet the fiscal rules.
Despite the track record of missed targets, these new rules offer some guidance whilst giving the government more scope to use fiscal policy. If economic growth is boosted as a result of more investment in infrastructure and innovation and giving some help to JAMs, any missed fiscal targets may well become as unimportant as the other missed ones. Importantly, in the meantime, the new "fiscal mandate" would have helped the Chancellor maneuver a delicate path.
Linda Yueh is an Adjunct Professor of Economics, London Business School.
