How Can Fiscal Rules Help?
A Track-Record of Failure
An all-weather fiscal framework
How Would the Framework Operate?
Would the framework survive economic storms?
Would It Provide Sufficient Incentive to Invest?
- ^ Jonathan Portes & Simon Wren-Lewis (2014), Issues in the design of fiscal policy rules, NIESR.
- ^ For instance, there is the well-known Taylor rule which links policy interest rates to the deviation of inflation from its target and the output gap (deviation of actual output from potential). Rules of this type have been used to represent monetary policy in macroeconomic models or as a benchmark against which to examine actual policy rates.
- ^ The UK is certainly not the only country to have struggled with the implementation of fiscal rules. For a discussion on fiscal rules in Europe see Wyplosz,C., et al (2019) Fiscal Rules in Europe, IFO Dice Report, Summer Vol. 17.
- ^ Richard Hughes, Jack Leslie & Cara Pacitti (2019) Britannia waives the rules, Resolution Foundation October
- ^ See Mulheirn, I. and Browne, J. (2019) Fiscal policy - a credibility deficit, UK General Election 2019 Briefing, Tony Blair Institute for Global Change, November.
- ^ See figure 2 in R Hughes, Seeking public value: The case for balance sheet targeting in fiscal policy, Resolution Foundation, September 2019
- ^ See Mulheirn & Browne (2019) op cit
- ^ Rishi Sunak under pressure from No 10 to relax fiscal rules in Budget, Financial Times, 14 February 2020.
- ^ Assuming current tax revenues and interest rates on government borrowing remain unchanged.
- ^ Analysis by the RF suggests that the 6 per cent rule could easily be breeched in the event of a range of shocks which is why they recommend a 10 per cent ceiling
- ^ According to simple arithmetic, in the long run the government debt to GDP ratio will converge to a value that equals the deficit to GDP ratio divided by the growth in nominal income. For instance a country that recorded a permanent deficit of 3 per cent of GDP with nominal income growing at 5 per cent per annum will ultimately achieve a debt to GDP ratio of 60 per cent of GDP (0.03/0.05) irrespective of whether its debt started at 40, 60 or 80 per cent of GDP.
- ^ The choice of a ten-year horizon for bond yields and potential growth is a simplification for illustrative purposes. In practice the calculation could be refined to reflect the average horizon of new debt issued by the government and relate this to the projected potential growth over the same period. Furthermore, it may also make sense for the OBR to make a projection for the evolution of RFC and FPO, e.g. for the next three years, so that it can project the future evolution of the adjusted deficit limit to help the government plan its finances.
- ^ Recent work by the Resolution Foundation (RF) proposes developing such a framework so that policy could act at speed (or at least more quickly than in the past) when a downturn comes. This could specify the circumstances in which fiscal policy would be used, how large the stimulus would be, and which taxes and spending measures would be adjusted in the event of a downturn. Importantly, a clear pre-announced framework could be fully understood and internalised by economic agents. The idea is that if people see a credible framework for fiscal intervention, they could be less nervous when the downturn hits and this moderation in adverse expectations could contribute to a shallower recession.
- ^ See the discussion on the net worth concept and statistical progress in R Hughes et al (2019), Totally (net) worth it: The next generation of UK fiscal rules, Resolution Foundation, October
- ^ In its March 2019 Economic and Fiscal Outlook, the OBR projected potential growth of 1.5 per cent in 2019 rising to 1.6 per cent by 2023
- ^ As already highlighted, the relationship between the debt and deficit targets is conditional on the growth rate of nominal GDP. Faster growth in nominal GDP would imply that a larger deficit could be tolerated for a given debt stock target.
- ^ The assumption of perfect foresight for inflation is likely to be broadly appropriate since 1997 once inflation expectations became broadly anchored around the Bank of England’s target. To the extent that the period of disinflation from the late-1970s to the mid-1990s was not fully anticipated, then the ex-ante real interest rates would not have been perceived to have been as high as implied by the chart. However, the chart does reflect the ex post cost of financing government debt.
- ^ FPO = 1.015^10 = 1.16
- ^ RFC = (1+0.06-0.02)^10 = 1.48
- ^ This calculation illustrates the direct impact of changes in the cost of finance and potential output growth on the adjustment to the baseline deficit. It abstracts from the impact of changes in the growth of nominal GDP on the relationship between the deficit and debt targets. By keeping the baseline deficit limit fixed at 2.5 per cent - which is consistent with a 70 per cent debt stock at the current growth of nominal GDP – any lasting changes in the growth of nominal GDP will be reflected in an adjustment to the implied target for the debt stock. So, when inflation and GDP growth were higher in the 1980s, a 2.5 per cent deficit would have been consistent with a lower debt to GDP ratio than 70 per cent. However, the growth rate of nominal GDP has averaged around 3.5 per cent since 2004, suggesting that the underling debt target of 70 per cent of GDP would have been consistent with a 2.5 per cent deficit over this period.
- ^ By adding one percentage point to nominal income growth an additional impact of a rise in potential growth could be to change the relationship between the underlying objectives for the deficit and the debt stock. If inflation remained unchanged, a 1 per centrise in the growth rate of potential output would raise nominal GDP growth from 3.5 per cent to 4.5 per cent per annum. This could allow the deficit limit to rise temporarily to 4.6per cent of GDP consistent with an unchanged longer-term debt objective of 70 per cent of GDP. Alternatively, the government could maintain the baseline deficit of 2.5 per cent and adjusted deficit limit of 3.6 per cent and reap the benefit of higher long-term growth in the form of a lower long-run target for the debt stock of 55 per cent of GDP.