Politicians cannot be trusted to set the fiscal rules

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On the last of these comments on the UK fiscal framework John considers the impact and role of borrowing limits

The fiscal framework set out for the UK in 1998 has two principal components. The golden rule states that current expenditure should match tax receipts over an economic cycle. The sustainable investment rule requires that net public sector debt should not exceed 40 per cent of gross domestic product. Spending and borrowing constraints are both sensible principles. But, as I explained in my column of July 23, worthy aims can have negative effects when they are cast as performance targets. Effort goes into meeting the targets, not the purposes of the targets.

The malign consequences have been evident in contexts as diverse as the economic planning system of the Soviet Union and the accounts of Enron, the remuneration systems of senior executives and the management practices of National Health Service hospitals. Factories meet their targets, debtors fulfil their covenants, managers win their bonuses and clinicians reduce their waiting lists – but output is not necessarily any bigger, nor finances sounder, shareholder value is not created and patient care is no better.

And so with the effects of these fiscal rules. The appearance of prudence, not prudence itself, was sought and rewarded. On July 23 I discussed the effect of the golden rule but the distorting influence of the sustainable investment rule has been much more serious. The British government has spent hundreds of millions in advisory and consultancy fees and much more in additional financing costs to circumvent constraints of its own devising.

Both the borrowing target and the content of the borrowing target are arbitrary. British government borrowing, about 70 per cent of GDP in the 1970s, is now a reported 40 per cent: a truer figure is probably between 50 per cent and 60 per cent, so that borrowing has fallen, even if not by as much as stated. With lower interest rates, interest is about 5 per cent of government operating revenues, conservative gearing by private sector standards.

But private sector standards are of limited relevance: government accounting is inherently different. The balance sheet has little meaning for the tax-imposing entity that determines what are and are not the liabilities of all economic agents, including itself. Arguments over what is, and is not, government borrowing are beside the point.

The question that needs to be posed is clear: “Do commitments imply a higher tax burden tomorrow than we experience today?” If they do, we are imposing obligations on our children and grandchildren that we are not ourselves prepared to shoulder. Let us call that the “sustainable tax burden question”. Answering this question would require the inclusion of contingent liabilities – for funding Railtrack or bailing out Northern Rock – to the extent that they are expected to materialise. Future pension costs are acknowledged insofar as we choose not to fund them or they exceed the costs of unfunded pensions we give to our grandparents. The sustainable tax burden approach recognises that the costs of unitary payments under private finance initiatives were always government obligations essentially identical to the interest costs that would have been incurred if the same expenditures had been recorded in the public sector.

Governments cannot be trusted to give an honest answer to the sustainable tax burden question themselves and to invite them to do so would lead to a new round of statistical distortions. Even if government had the best intentions – a big if – too many issues in estimation of the sustainable tax burden involve judgment and subjectivity to ask people whose career progress depends on pleasing ministers to make the assessment.

Give this responsibility to a fiscal policy commission. It should not have the job of setting tax rates, so the analogy with the Bank of England’s monetary policy committee should not be stretched too far. But the FPC should compile an independent audit and, as with the MPC, its members should have such authority that it cannot be bullied. Without such an institution, the new fiscal framework which the government plans will be tarnished from inception by the loss of credibility of the old.

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