Next government ‘should ditch public sector debt target’

21 May 14
The next government should not repeat the coalition’s use of a fiscal target based on reducing public sector debt, but instead base rules only on a five-year target for borrowing, two leading economists have said.

By Richard Johnstone | 21 May 2014

The next government should not repeat the coalition’s use of a fiscal target based on reducing public sector debt, but instead base rules only on a five-year target for borrowing, two leading economists have said.

In an analysis of the design of fiscal rules by governments, Jonathan Portes, director of the National Institute of Economic and Social Research, and Simon Wren-Lewis, professor of economics at the University of Oxford, concluded that a new approach to fiscal policy rules was needed.

The current UK government has two targets – a mandate stating that the structural current budget must be balanced by the end of a rolling five-year forecast, and a supplementary target for public sector net debt to be falling as a share of national income in 2015/16.

Chancellor George Osborne’s budgets have met the first rule by forecasting a current surplus over five years – although the actual date itself has been pushed back – but the supplementary target is unlikely to be met.

In their paper, Portes and Wren-Lewis said future fiscal rules should not target public sector debt.

‘Theory suggests that government should, as far as possible, smooth taxes and its recurrent consumption spending, which means that government debt should act as a shock absorber, and any planned adjustments in debt should be gradual,’ they stated.

‘This suggests that operational targets for governments should involve deficits rather than debt, because such rules will be more robust to shocks.’

Ahead of the 2015 general election, Chancellor George Osborne has pledged to run an absolute surplus on spending by the end of the next parliament, while shadow chancellor Ed Balls said Labour would balance current spending.

Portes and Wren-Lewis said any target should be set for all new borrowing and not just for current spending. However, to deal with the UK's historic tendency to short-termism, a specific target for the ratio of public investment to gross domestic product should also be part of the regime.

Maintaining a five-year deficit target should provide a long enough timeframe so there is no need for the target to be cyclically adjusted, they added.

However, rules should only apply where interest rates are above their zero lower bound. This is the situation where short-term nominal interest rate in an economy are at or near zero, reducing the impact of monetary policy. In these cases, the fiscal and monetary authorities must be free to cooperate to formulate a fiscal expansion package that would allow interest rates to rise above this level.

As well as introducing new targets, the next government should also give the Office for Budget Responsibility an expanded remit to consider whether the government is observing both the letter and the spirit of the regime. This would address what Portes and Wren-Lewis called the ‘temptation’ to meet rules by moving spending on- or off-balance sheet.

‘This combination of rules is based in economic theory, but flexible enough to cover a wide range of economic circumstances, with independent expert judgement to minimise ­– if not eliminate – the temptation for governments to manipulate the rules would be the best way forward for the UK,’ they concluded.

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