UK Government’s Fiscal Constraints Threaten Key Investments and Tax Cuts
UK Finance Minister Grant Shapps has warned that “money is not infinite,” indicating the challenges faced by the government in terms of public spending constraints. These constraints are preventing the administration from implementing tax cuts or investing in vital projects such as the North-South rail link HS2. In order to address these limitations, the Labour Party, if successful in the upcoming election, will need to alter existing rules in order to secure the necessary funds for important expenditures.
Having fiscal rules and adhering to them is crucial for any government, especially in the case of the UK. Prime Minister Liz Truss caused a bond market crisis last year by proposing unfunded tax cuts. However, the current fiscal constraints, which primarily focus on debt reduction, fail to capture the full financial position of the country. This prevents the government from investing in future growth. To rectify this, a broader measure of the UK balance sheet, alongside borrowing limits, should be adopted by the next Prime Minister.
Currently, Prime Minister Rishi Sunak is expected to manage the economy in a way that ensures public sector net debt decreases relative to GDP over a five-year period. According to the Office for Budget Responsibility, this measure leaves Finance Minister Jeremy Hunt with just £2.8 billion to allocate towards tax cuts or investments until March 2028. Consequently, Hunt has expressed skepticism about fiscal giveaways in the upcoming November budget, while Sunak is contemplating delaying parts of HS2 and reducing state pension costs.
Unfortunately, this fiscal austerity is detrimental to the country’s economic prospects, as it falls short of the necessary public and private investment. Without a reassessment of the current situation, the UK will struggle to boost productivity and its growth will lag behind other major economies. The Bank of England predicts an anaemic GDP growth of 0.5% next year and 0.25% in 2025, with long-term growth projected at just 1%.
A potential solution comes in the form of the Labour Party, which currently leads Sunak’s Conservatives by 44% to 27% in the polls. If they win the next election, expected in late 2024, Labour would need to introduce new rules. Instead of fixating on debt, a Labour-led administration, under the leadership of Keir Starmer, could adopt a broader metric known as “public sector net worth” (PSNW).
PSNW measures the overall value of the public sector’s assets minus its liabilities, providing a more holistic view of the country’s financial position. In the UK, PSNW, excluding public sector banks, showed a deficit of £617.8 billion in August, equivalent to around 24% of GDP. The largest component of assets is £1.6 trillion worth of “non-financial assets,” which includes a significant amount of government-owned properties. Currently, these properties are valued at historical cost, but a more realistic accounting method could increase their value by up to 80%, according to experts.
Moreover, the UK also has approximately £665 billion in “other financial liabilities,” which encompass future payments to government retirees. Under a PSNW approach, the government could use its assets to fund these liabilities. For instance, it could invest funds borrowed in a portfolio of private and listed securities, similar to a sovereign wealth fund, and utilize the returns from these assets to finance pension liabilities over time.
Implementing PSNW accounting would offer the UK greater fiscal headroom to undertake further investments. The metric is expected to grow by 2.6% of GDP by March 2028, unlocking an additional £65 billion for borrowing. In contrast, public sector net debt is projected to decline by only 0.7% of GDP by the same date, resulting in only £17.5 billion of additional funds. New Zealand, which adopted the PSNW approach in 1989, has witnessed consistent improvement in public net worth, with the exception of a few challenging years after the 2008 financial crisis, the 2011 earthquakes, and the recent pandemic.
Despite the potential benefits, the Labour Party is concerned that revising debt rules may unsettle bond investors, who still bear the scars of Truss’s fiscal missteps. This leaves Labour leader Keir Starmer vulnerable to attacks from the Conservative Party, who may argue that his party is fiscally irresponsible and untrustworthy. In response, Labour’s potential finance minister, Rachel Reeves, recently pledged to “reduce national debt as a share of the economy.”
However, it is essential to note that wise creditors consider the growth prospects of the asset side of the balance sheet, in addition to the debt burden. Furthermore, Reeves would need to introduce rules to control debt, such as prohibiting borrowing for current expenditures, keeping debt interest payments below a set percentage of GDP, or ensuring a balanced national budget over the economic cycle. The next UK government must avoid fixating on restrictive fiscal rules at the expense of investments that could help the country recover from its current challenges.
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