Analysing UK Fiscal Policy

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Executive summary

The Government has taken significant steps to strengthen the framework for fiscal policy since taking office. Fiscal policy is now directed firmly towards maintaining sound public finances over the medium term, based on strict rules. Where possible it supports monetary policy over the economic cycle. This approach, together with the new monetary policy framework, provides the platform of stability necessary for achieving the Government's central economic goal of high and sustainable levels of growth and employment.

High quality external scrutiny of the conduct of fiscal policy plays a key role in ensuring that the benefits of the new framework are delivered fully. This paper aims to help understanding by providing a guide to analysing fiscal policy under the new framework.

It is important to understand the role each fiscal aggregate plays in analysis of policy. Using an inappropriate aggregate can result in misleading conclusions. For example, while the public sector net cash requirement is a good measure of the public sector's financing needs, it is not the best measure of the impact of fiscal policy on the economy or the long-term sustainability of fiscal policy.

The paper focuses on decisions regarding the key fiscal policy aggregates, rather than decisions about individual spending or taxation policies, important though these are.

In addition to meeting the Government's key microeconomic objectives, decisions taken in the Budget on taxation and spending - and the balance between them - reflect the Government's key fiscal policy objectives of:

over the medium term, ensuring sound public finances and that spending and taxation impact fairly both within and across generations. In practice this requires that:
the Government meets its key taxation and spending priorities while avoiding an unsustainable and damaging rise in the burden of public debt; and
those generations who benefit from public spending also meet, as far as possible, the costs of the services they consume; and
over the short term, supporting monetary policy, where possible, by:
allowing the automatic stabilisers to play their role in smoothing the path of the economy in the face of variations in demand; and
where prudent and sensible, providing further support to monetary policy through changes in the fiscal stance.

The new fiscal framework has been designed carefully to deliver these objectives. Central to the framework are five principles of fiscal management:

transparency in the setting of fiscal policy objectives, the implementation of fiscal policy and the publication of the public accounts;
stability in the fiscal policy-making process and in the way fiscal policy impacts on the economy;
responsibility in the management of the public finances;
fairness, including between generations; and
efficiency in the design and implementation of fiscal policy and in managing both sides of the public sector balance sheet.

These principles were enshrined in the Finance Act 1998 and in the Code for Fiscal Stability, approved by the House of Commons in December 1998. The Code explains how these principles are to be reflected in the formulation and implementation of fiscal policy.

The Government has specified two key fiscal rules that accord with these principles. These are:

the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending; and
the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level.

The fiscal rules provide benchmarks against which the performance of fiscal policy can be judged. The Government will meet the golden rule if, on average over a complete economic cycle, the current budget is in balance or surplus. The Government also believes that, other things equal, a modest reduction in net public sector debt to below 40 per cent of GDP over the economic cycle is desirable.

The Government recognises that the composition of the Budget can have an important bearing on its economic effect over both the short and long-term. However, as a first approximation, and in the absence of a significant compositional shift in taxation and spending in the Budget, the key indicator for assessing the overall fiscal impact is the change in public sector net borrowing (PSNB). Fiscal policy adds to demand when there is an increase in PSNB and subtracts from demand when PSNB falls.

The overall fiscal impact is therefore made up of changes in:

that part of PSNB resulting from cyclical movements in the economy, ie through the operation of the automatic stabilisers; and
that part of PSNB resulting from changes in the fiscal stance (which is equivalent to changes in cyclically-adjusted or structural PSNB).

The Budget projections of cyclically-adjusted PSNB indicate the extent to which the Government is planning to undertake a discretionary tightening or loosening of the fiscal stance. This tightening or loosening may come about due to one or both of:

a discretionary Budget measure to achieve the desired change in the fiscal stance; and
a Budget decision to accommodate or offset the impact of non-discretionary factors that are expected to affect the fiscal stance.

These concepts help to explain the process by which decisions are made in the Budget. A judgement is reached about the appropriate fiscal stance given the need to meet the fiscal rules. This judgement also takes into account the need to ensure, as far as possible, that the overall fiscal impact supports monetary policy through the economic cycle. The Government then implements discretionary Budget measures to the extent that they are necessary to deliver the appropriate fiscal stance, taking into account the impact of non-discretionary factors which change the baseline fiscal projections (including pipeline measures).

In setting fiscal policy, the Government takes a deliberately cautious approach. This has to balance the costs of potentially underachieving the fiscal rules against those associated with running an unduly restrictive fiscal policy stance. It also recognises that some adjustment of the fiscal stance is possible within the cycle, if actual outturns and updated projections suggest the Government is no longer likely to meet its objectives.

This prudent approach is implemented, among other things, by adopting a cautious assumption about the economy's trend growth rate. The Government's economic policies are designed to raise this growth rate beyond the level assumed for fiscal policy purposes. For the purposes of fiscal planning, however, it would not be prudent to take credit for any success of these policies until firm evidence emerges. This approach ensures the risks of costly policy reversals are minimised.

Under the Code for Fiscal Stability, the Government is committed to publishing a Pre-Budget Report (PBR) at least three months prior to the Budget. One of the roles of the PBR is to increase transparency, which it does in two key ways. First, it provides an opportunity for the Government to consult the public on specific policy initiatives under consideration for the forthcoming Budget. Second, it presents an update on the outlook for the economy and the public finances, taking into account economic and other developments since the Budget.

It is important to note that the public finance projections contained in the PBR present an interim forecast update. The PBR projections do not necessarily represent the outcome the Government is seeking. They have a quite different status to the projections contained in the Economic and Fiscal Strategy Report (EFSR) and Financial Statement and Budget Report (FSBR) at Budget time. The figures presented are preliminary and the projections are subject to change in the period before the Budget. Forecast errors can be large, even in the near term. A further assessment is made at Budget time before decisions are taken to ensure the fiscal rules are met.

Updated fiscal projections will be presented in the Pre-Budget Report to be published on 9 November 1999. However, applying this approach to the Budget 99 projections shows:

the Government was well placed to meet its medium-term objectives - the fiscal rules were on track to be met over the current cycle on both projections of the surplus on current budget and public sector net debt. The prudence of the Government's medium-term plans was also reflected in public sector net worth which was forecast to rise slightly following years of marked decline.
following several years of necessary tightening of the fiscal stance to restore sound public finances, the decisions taken in Budget 99 were projected to lock in this tightening by leaving the fiscal stance virtually unchanged over the forecast period (that is, cyclically-adjusted PSNB was projected to remain broadly constant). Actual PSNB was projected to rise a little into 1999-2000, so that the automatic stabilisers could play their role in supporting monetary policy. This decision was taken against a backdrop of a slowing domestic economy following weaker world growth.