New Government, New Fiscal Rule

11 June 2015

George Osborne used last night’s Mansion House speech to usher in a “new settlement for the way we manage our public finances”. The Chancellor announced a rule that legally binds the Government to run an absolute budget surplus in ‘normal’ times. This policy was first proposed by Osborne in 2013, and was present in the Conservative Party Manifesto. It is not yet clear whether it will supplant or complement the existing requirement to balance the cyclically-adjusted current budget within a rolling, three-year window.

The Chancellor will require the independent Office for Budget Responsibility (OBR) to judge when the criteria are met; Parliament would then be required to set out how and when the budget will return to surplus.

When making fiscal rules, governments have a choice: countries with untrusted institutions require strict rules to ensure that governments cannot game them with creative accounting. Countries with strong institutions, capable of monitoring government policy, can be given more leeway to determine the optimal fiscal path.

Osborne’s emphasis on running a budget surplus in every normal year follows the first route. His focus on the deficit is to be commended: running large deficits when the economy is growing has contributed to a ratcheting effect in the UK, where debt builds up in recessions but is not paid off in the good years. However, Osborne’s insistence on an absolute budget surplus means tax revenues will be required to cover both departmental and infrastructure spending. This produces the inequitable result that money for today’s public services and social security will fund the infrastructure built for tomorrow.

Stringent rules might be required if the Chancellor did not have a trustworthy body to monitor fiscal policy decisions. But he does: the OBR. The OBR’s scrutiny ensures he cannot game the system by adopting, for example, convenient definitions of capital and current, or structural and cyclical, spending. The OBR could be used to allow the Chancellor to commit to more flexible rules, able to adapt to the economic conditions of the time.

However, it is unclear how the new policy will deal with recessions, since announcements so far concern only normal times. The challenges of this recession highlight the need for effective guidance and during downturns. A fiscal rule that guides policy could provide a measure of reassurance and certainty about how future crises will be handled.

 Alexander Hitchcock, Research Assistant, Reform

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