Fiscal Rules

A number of different “fiscal rules” have been deployed at different times by the UK and other governments. The stated, broad aims of all of them are to impose some predictability on the operation of fiscal policy – and thereby encourage confidence, and to prevent governments from manipulating fiscal policy for electoral purposes.

Examples

Early examples are: the Gramm-Rudman-Hollings Act of 1985 in the US, which aimed to impose automatic spending cuts in the event of a budget deficit; the Maastricht Stability and Growth Pact initiated in 1997, which set an upper limit on EU budget deficits and government debt as a percentage of GDP; and the Golden Rule of UK Chancellor Gordon Brown, which aimed to ensure that over the economic cycle the Government would borrow only to fund capital not current expenditure.

All these have faced two main challenges. If they are too rigid they soon appear inappropriate and lose support and credibility: for example, the automatic expenditure cuts proposed under Gramm-Rudman-Hollings in the event of a deficit were subsequently deemed unconstitutional. If the rules are too flexible they can become made irrelevant by politicians keen to circumvent them: for example, many countries were thought to have used highly “creative accounting” to ensure they “met” the conditions required under the terms of the Maastricht Stability of Growth Pact; and Gordon Brown at one point re-defined the length of the economic cycle, which ensured his rule was “met”.

Current UK Rules

Currently in the UK (March 2016) there are two main proposed fiscal rules. The key to the Conservative Government’s fiscal rule is the aim to achieve, “in normal times”, a surplus on public sector net borrowing. Another ingredient is that this rule applies “unless and until the Office for Budget Responsibility (OBR) assess, as part of their economic and fiscal forecast, that there is a significant negative shock to the UK. A significant negative shock is defined as real GDP growth of less than 1% on a rolling 4 quarter-on-4 quarter basis. If the OBR assesses that a significant negative shock occurred in the most recent 4 quarter period, or is occurring at the time the assessment is made, or will occur during the forecast period, then, if the normal times surplus rule is in force, the target for a surplus each year will be suspended. In which case the Treasury must set out a plan to return to surplus. This plan must include appropriate fiscal targets, which will be assessed by the OBR.

The Labour Party’s fiscal rule has the following key ingredients: (i) the achievement of a balance on the current balance over a rolling five-year forecast; and (ii) a suspension of the rule if the Bank of England’s Monetary Policy Committee (MPC) judges it could not reduce its interest rates any further to stimulate growth.

Both rules aim to secure a fall in national debt as a proportion of GDP. And both aim to constrain fiscal policy whilst allowing some flexibility in the face of unusually difficult macroeconomic conditions. In both cases this flexibility is to be “policed” by a supposedly independent agency: the OBR in one case; the Bank of England’s MPC in the other.

Two key differences

First, the Conservative Party’s fiscal rule aims for an overall surplus (in normal times), i.e. it aims for tax revenue to exceed the sum of current and capital government expenditure. The Labour Party rule aims only for a current balance of zero, i.e. for tax revenue to equal current government expenditure; it is therefore similar to Gordon Brown’s Golden Rule. The Labour Party’s rule is therefore looser since it allows the government to run an overall deficit; consequently it may achieve a slower fall in national debt as a proportion of GDP. However, it also allows the government greater freedom to borrow at interest rates that are currently very low to finance capital projects such as expenditure on flood defences, roads and school buildings. And since this boosts aggregate demand, and perhaps also improves the long-run performance of the economy, it may quicken the reduction in the debt to GDP ratio by raising GDP.

Secondly, the Conservative Party’s fiscal rule can be suspended if growth falls below 1%. The Labour Party’s rule can be suspended if the Bank of England’s Monetary Policy Committee judged it could not reduce its policy interest rate any further to stimulate growth. In current circumstances, with UK interest rates close to zero, the Labour Party’s rule probably offers greater fiscal flexibility.