Experience over the last 20 years suggests that pursuing a narrow debt target, underpinned by strict accounting conventions, can push politicians towards under-investing in infrastructure and inappropriately favouring private finance and asset ownership over the public alternative. But that need not be the case.
Every chancellor since Gordon Brown has signed up to some sort of fiscal rule limiting public debt, alongside one limiting annual borrowing.
The advantages of such fiscal rules are, in principle, two-fold. They reassure the public and investors that the government will be a prudent steward of the public finances. This was a crucial objective for the incoming Labour government in 1997. John McDonnell has also used Labour’s proposed fiscal credibility rule to defend against any suggestion that he would be a fiscally irresponsible chancellor.
Fiscal rules can also help insulate the chancellor from pressure from cabinet colleagues to loosen the purse strings to fund giveaways for favoured areas, which would potentially undermine the long-term health of the public finances in pursuit of short-term political gain. The coming months will provide a test of how strong a weapon this is for Philip Hammond as other ministers line up to make bids for extra money following the announcement of a birthday present for the NHS.
But in practice the debt targets in place since 1997 have led to some undesirable outcomes. Rigid adherence to the letter but not the spirit of the debt targets has created incentives for the Treasury to sell off public assets merely to help reduce headline debt, and inappropriately to favour private over public financing of infrastructure.
The spirit of the debt targets that UK chancellors have signed up to is a commitment to strengthen – or at least not substantially weaken – the UK’s balance sheet position. In practice the official definition of public debt that has been targeted is a measure of accumulated debt issuance, net of any short-term financial assets – but not other assets – held by the public sector.
Investing public money in new infrastructure will raise this measure of debt, even though in return the public sector may acquire a valuable asset that could boost future growth and tax revenues. Conversely, selling off a government asset for less than its market value will improve this measure of debt, even though it weakens the government’s underlying financial position.
The political saliency of the headline measure of debt increases the attractiveness of private financing to ministers because privately financed projects do not contribute to public sector debt.
The Institute for Government has heard accounts from many public sector officials who were told to push as much infrastructure and other spending as possible off the government’s balance sheet. The case of Metronet in the mid 2000s is a prominent example of a problematic private finance initiative that had been dictated by a desire to keep the costs off the government balance sheet. But the bias in favour of private finance seems to have continued more recently, at least to some extent, despite the 2012 revamp of the private finance initiative, which was intended to address these shortcomings.
While using private finance will be the best option in some cases, using it solely to keep projects off the public sector balance sheet is unlikely to deliver best value for money. Ultimately, it will result in higher-than-necessary costs for infrastructure investment and consequently less money available for other investments.
It is tempting to suggest that the accounting rules should be changed or a different measure of debt should be targeted to remove the incentives to game the rules in this way. But neither approach would be a simple panacea.
Changing accounting conventions is difficult – because they are governed by internationally agreed standards – and could be undesirable – since the agreed definitions are used for other purposes beyond the fiscal rules.
Targeting a different measure of debt is possible. But any new measure could simply have some other loophole that could be similarly exploited. There needs to be a more fundamental change in the government’s approach to meeting the fiscal targets.
To avoid decisions about whether and how to finance infrastructure being driven by an excessive focus on whether or not a new project will add to the targeted measure of public debt, the Treasury should be more transparent about how decisions are made and what the costs and benefits were judged to be of alternative ways of financing the investments. Such transparency would help those outside government assess whether decisions had been made simply to meet the letter but not the spirit of the debt target.
The existence of the Office for Budget Responsibility, as a well-informed independent monitor of fiscal decisions, should bolster a chancellor’s ability to maintain fiscal credibility while using public money for worthwhile infrastructure investment – particularly if the Treasury is more transparent about the basis on which any decisions have been made.
Experience under Labour, coalition and Conservative governments has shown that an excessive fixation on meeting the letter of the fiscal rules but losing sight of the underlying principle can lead to undesirable outcomes. It is difficult to write down a set of rules that would guard against all political gaming. But greater transparency about the basis on which investment decisions are made would help the OBR and other independent observers judge whether government actions meet the spirit as well as the letter of the rules.