Following the 2022 Truss/Kwarteng mini-budget which resulted in UK borrowing costs soaring, both main UK parties have reaffirmed their commitment to fiscal rules. But the specifics of these rules should be reassessed so they do not constrain future productivity growth and hence the next Government’s ability to improve public services, writes Thomas Aubrey.
Whoever wins the pending UK General Election will face a number of significant economic challenges. For example, polls show that many voters want the next government to improve public services such as the National Health Service, which currently has more than seven and a half million patients waiting to be treated, but this and other needs will require more investment. This raises the question of how improved public services can be funded. Neither the Conservative nor Labour Party appears to be advocating for major tax increases, and both parties have committed to abide by their fiscal rules – which are close, but not identical.
One imperative, albeit a challenging one, to improve the fiscal possibilities in future would be for the next government to support industry to help lift the rate of productivity growth which has slumped in recent years. Although labour productivity grew at 2.6% per annum between 2019 and 2023, the performance of the private sector has been underwhelming at just 1.2% over the period or 0.3% per annum as shown in Table 1. This compares to 1.7% growth in labour productivity per annum for the private sector between 1997 and 2006.
Table 1: Sectoral productivity disaggregation 2019 – 2023[1]
The disaggregation of the contributions to productivity growth highlights two potential areas for policy to explore. First, is the ongoing negative contribution of the manufacturing sector to the UK economy. It is a high value-added sector of £48.10 per hour compared to the economy-wide average of £38.64. And although many firms have increased their value-added, this has been cancelled out by growing reallocation of labour to lower value activities This indicates weaker competitiveness in UK manufacturing which cannot increase growth in its most valuable activities fast enough.
Since the Brexit referendum the manufacturing sector has contributed negatively towards productivity growth as UK firms are now at a competitive disadvantage with regards to exporting to the European Union. Hence the next government should look to renegotiate the Trade and Cooperation Agreement (TCA) with the European Union for those manufacturing sectors that request regulatory alignment. This is unlikely to be quick or easy, but as noted by the Centre for European Reform these types of agreements with the EU’s neighbouring countries are not unprecedented.
Table 1 also highlights three services sectors that are contributing positively towards overall productivity growth including Financial Services, Professional & Scientific, and Information & Communication. The question here is what could be done to help support these sectors to grow faster?
One policy option is to improve the built environment around key growth locations making them denser and able to support faster expansion of knowledge-intensive industries. In 2017, the National Infrastructure Commission argued that if transportation and housing were not significantly improved along the Oxford to Cambridge corridor this would constrain growth of some of the UK’s highest value-added firms. To deliver this, however, would require a large amount of investment in new infrastructure which brings the debate back to fiscal rules and whether they can be a hindrance to future growth.
The Treasury introduced the following fiscal targets in 2022:
- to have public sector net debt (excluding the Bank of England) as a percentage of GDP falling by the fifth year of the rolling forecast period.
- a target to ensure public sector net borrowing does not exceed 3% of GDP by the fifth year of the rolling forecast period.
Labour have agreed to quite similar fiscal targets as set out by Rachel Reeves in her Mais Lecture:
- debt must be falling as a share of the economy by the fifth year of the forecast.
- the current budget must move into balance so that day-to-day costs are met by revenues.
Reeves’ rule to move the current budget into balance is intended to replace the existing rule of ensuring total net borrowing does not exceed 3% of GDP by the fifth year of the rolling forecast, but both parties want to see debt fall by the fifth year of the forecast as a percentage of GDP.
The debate on fiscal rules has unsurprisingly ignored the geeky question as to what actually counts as public debt. The current debt measure used is public sector net debt (PSND) which excludes the Bank of England and public sector banks (financial public corporations), but includes general government debt in addition to the debt of non-financial public corporations. The inclusion of non-financial public corporations is different to how the EU assesses public debt in relation to its excessive debt procedure which can be understood as an EU-wide fiscal rule. The question is whether it really matters from a growth perspective to exclude or include the debt from non-financial public corporations in a fiscal rule?
The Office of National Statistics (ONS) follows the European System of Accounts (ESA) to classify entities as public corporations if they are a public body but are considered market entities which means at least 50% of its revenues are derived from market participants rather than taxation. Hence the BBC is not considered a non-financial public corporation given its license fee is considered by ONS to be a tax, whereas the Housing Revenue Account (HRA) is a non-financial public corporation given that its debt is largely covered by the revenue streams from tenants. If the UK were to use non-financial public corporations to issue debt to invest in new towns and urban extensions and market participants were covering a majority of the debt liabilities it would be included in the UK’s fiscal rule, whereas if a Dutch non-financial public corporation did the same it would be excluded.
Given that the UK’s infrastructure stock as a percentage of GDP is 57% compared to a benchmark of 70%, such rules may in fact be placing the UK at an economic competitive disadvantage. In a recent article Nicholas Macpherson the former permanent secretary at the Treasury, and unsurprisingly keen on fiscal discipline, noted with regards to fiscal rules that: “The British people rightly have never shown much interest. And the markets generally discount them.” The Truss episode shows there are limits to this, but while it might be true that most people care little about the detail of fiscal rules including what does and does not count as public debt, such detail may matter more than voters or markets think.
[1] The sectoral disaggregation uses GEAD (Generalized Exactly Additive Decomposition) based on Tang & Wang 2004. The ‘within’ effect is productivity growth in activities within the sector whereas the ‘between’ effect measures the reallocation of labour between sectors. E = estimated as ONS does not currently publish these values.
The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.
