The debt ratchet

Reform publishes new research on the public finances and the fiscal framework.

Click here to read the full report. The Twitter hashtag is #debtratchet.

Reform‘s research has discovered a “debt ratchet” that causes government debt to rise more in recessions than it falls in times of growth. It argues that an independent fiscal body with powers to raise and lower taxes, including VAT, income, and corporate tax, is needed to secure the public finances.

Over the past 20 years, the UK has seen larger government deficits in recessions than surpluses in booms. As a result, Reform estimates that this year’s national debt is £124 billion higher than it would be in the absence of the ratchet effect. This is equivalent to £4,700 of unnecessary government debt for every UK household.

The report warns that successive governments’ fiscal forecasts have been unreliable. 21 of the 25 official forecasts since 2002-03 have predicted that the public finances would move back into surplus. In fact they have remained in deficit for all of that time.

As a result the Chancellor is right to propose a new framework to protect the public finances. But the think tank warns against the introduction of a new fiscal rule. Both Gordon Brown and George Osborne abandoned their fiscal rules in crisis conditions because to obey them would have imposed too great a cost on the economy.

Instead the Office for Budget Responsibility should be gradually developed over time. Eventually the OBR would be given the power to adjust VAT, income, and corporate tax rates to ensure fiscal sustainability. The Chancellor should look to the success of other independent policy-making bodies, in particular the Bank of England’s independent setting of interest rates, and apply these lessons to fiscal policy.

Key figures in the report include:

  • Today, without the debt ratchet, the national debt would be £124 billion lower, equivalent to £4,700 for each of the 26.4 million households in the UK. It would stand at around 68 per cent of GDP rather than the actual level of 76 per cent.
  • Over the last 20 years, for every percentage point that the economy shrunk below capacity in a recession, the deficit has grown by 1.1 per cent. Yet, for every percentage point it expanded above its maximum capacity in a boom, the deficit shrunk by less than 0.7 per cent.
  • If the debt ratchet had not existed, in 2010 public net debt would have been nearly 14 per cent lower i.e. it would have stood at 54 per cent rather than 62 per cent of GDP. A smaller deficit and lower debt would have given the Chancellor greater freedom to respond to the exceptional circumstances of 2008.
  • 21 of the 25 official forecasts since 2002-03 have projected a structural surplus by the end of the forecast period. In fact the structural budget remained in deficit the entire time.