British government designs fiscal policy within a flawed framework – result = poor policy

This week, the UK Chancellor releases the latest fiscal statement (aka ‘the budget’) and will also have a eye to the general election which must be held before January 28, 2025. One would expect the government would stall the announcement and delay the election for as long as is possible, given the current situation and the cumulative impacts of 12 years of Tory rule, which are plain to see at all levels of British society. All the talk is of tax cuts, that typical ‘sugar hit’ approach to winning votes that soon works it way out of the system. The debate as to what the British government should now be doing is clouded, as these debates are always clouded, by the input of organisations such as the Office of Budget Responsibility, which claims its charter is to “to examine and report on the sustainability of the public finances”, yet consistently provides input which is irrelevant to the substance of the issue and just feeds the flawed political scrum. In the end, the policy choices are not based on the actual opportunities and threats that are available to and confront the currency-issuing government but rather a fictional mindset that all the players are trapped within.

On the ‘sugar hit’ tax cut strategy helping win elections, the most immediate example is last weekend in Australia where the current Labor government won a by election against all odds, which was caused by the death of a sitting member, by offering a new round of tax cuts to low- and middle-income voters.

But in general such a sugar rush dissipates fairly quickly and if the British government thinks tax cuts, which are being pushed by the Prime Minister, will solve their acute political disadvantage at present then I think they will be disappointed.

12 years of damaging austerity cannot be easily undone even though Labour offers very little that is different, which is a problem facing voters across the world – the convergence of the progressive and conservative political parties somewhere on the right of centre.

That convergence is driven by the fact that both sides of politics have become captured by the dominant mainstream macroeconomic narrative that so restricts the fiscal opportunities that are provided to governments by economic analysis and commentary that there is no room left for much policy variation.

So while Labour-type parties around the world try to pretend they are fairer or more enlightened about the contemporary issues such as poverty, inequality, precarious work, climate change etc, the options they perceive after being briefed by these economists are so narrow that the ‘talk’ is not much more than pretence.

Witness the recent surrender by the British Labour leadership on climate – where a ‘grand-plan’ (which wasn’t so grand anyway) has been abandoned because they have been told Britain ‘cannot afford it’.

We will see what the increasing climate chaos does for affordability – true affordability in the coming years as a result of the inaction that this type of thinking spawns.

The current fiscal debate in Britain is now being structured by the input form the Office of Budget Responsibility (OBR) which has convinced the political class, the media, and hence the ‘people’ that ‘fiscal headroom’ – in the way they define it – is a concept that is portent and drives the political choices taken with respect to spending and taxation decisions.

The problem is that their concept of ‘fiscal headroom’ is largely meaningless and certainly not an appropriate framework within in which to make choices that will influence the direction of British society in the coming years – and, not to put too finer point on it – determine whether Britain can survive the climate onslaught that is upon it (and the rest of us).

Just last week (February 29, 2024), the UK Guardian article – Hunt scrambles to raise revenue as OBR slashes scope for tax cuts in budget – reflected the diversions that the OBR provides to sensible debate, when it reported that:

Recent forecasts from the Office for Budget Responsibility (OBR) are said to have given the chancellor less fiscal headroom than hoped, pushing him to consider unexpected tax rises such as abolishing the non-dom tax status.

The OBR defines ‘fiscal headroom’ in terms of pre-defined “fiscal targets” or fiscal rules.

The procedure is for the government to legislate ‘fiscal targets’ and then the OBR evaluates the policy options in terms of “likelihood of” the targets “being met on current policy under our central forecast” (Source).

The fiscal rules are defined in the so-called – Charter for Budget Responsibility – which then conditions the work of the OBR within the fiscal framework.

Once you get your head around the mechanics it soon becomes clear that this is a sort of circular, self-reinforcing loop which starts with a fiction and then engages various governmental bodies to jump hoops within that fiction, with no real applicable knowledge being generated in the process.

The OBR is full of highly educated people with the latest computing technology engaging in what is essentially a futile activity.

Even using their own logic, trying to achieve pre-defined ‘financial’ targets is futile because the final fiscal outcome is driven largely by the spending and saving decisions of the non-government sector – households and firms.

The government policy settings influence those decisions but the government cannot control the final outcomes.

And in trying to achieve pre-defined ‘financial’ targets, policy often veers away from the desirable and the results cause wider disparities from actual and intended.

For example, when a government engages in an austerity plan designed to reduce the fiscal deficit and embarks on spending cuts, the resulting multiplied effects on the non-government sector – rising unemployment, lost income, etc – reduces consumption and private investment expenditure – which push the economy towards or into recession and that results in less tax revenue and higher welfare spending by government – and … a higher fiscal deficit.

The policy that is driven by a flawed starting point ends up failing exactly because its starting point was flawed.

So in Britain, the latest fiscal framework defined the fiscal targets in terms of:

1. “to have public sector net debt (excluding the Bank of England) as a percentage of GDP falling by the fifth year of the rolling forecast period”.

2. “a target to ensure public sector net borrowing does not exceed 3 percent of GDP by the fifth year of the rolling forecast period”.

3. “a target to ensure that expenditure on welfare is contained within a predetermined cap and margin set by the Treasury”.

They claim that:

A prerequisite for sustainable public finances is the continued affordability of public debt, which the Treasury will monitor closely. The
Treasury’s fiscal mandate and supplementary targets allow the government to maintain high levels of investment spending when borrowing costs are low. However, the opportunities presented by low borrowing costs must be balanced against other considerations relating to the affordability of debt servicing including its sensitivity to changes in the macroeconomic context and outlook, and wider risks such as the proportion of government debt issuance held overseas.

There are usually supplementary targets such as (in 2020-21) “To balance the current budget by the third year of the rolling forecast period.”

The government fiscal process is like this:

1. It defines these financial rules.

2. It commissions the OBR to make forecasts of the fiscal and economic outcomes in the year ahead.

3. It prepares its fiscal statement based on these forecasts.

4. OBR calculates what it calls ‘fiscal headroom’ which they define as how much space there is between their forecasted policy outcomes and the fiscal targets.

5. The estimated ‘headroom’ then drives the public debate about what the policy options are.

So there is an elaborate labyrinth of concepts and calculations that support this framework.

And the reality is that they are all irrelevant to the true purpose of fiscal policy, which is to enhance the well-being of the people of Britain while providing a sustainable ecological footprint.

The government process really defines fiscal policy within a circular logic – the rules that are independent of the real factors that drive well-being and environmental sustainability.

The circularity is as follows:

Fiscal rule -> OBR evaluation -> Policy -> Outcome within rule = good policy/ breaks rule = bad policy.

Who cares about the people or the land or the sea or the atmosphere!

The problem is (as above) that the ‘headroom’ narrative drives the policy choices.

So the UK Guardian article cited above claimed that the Chancellor:

… received the most recent forecast this week and will get another on Friday clarifying how much he can spend on tax cuts while remaining on track to meet his debt-reduction target …

The OBR has concluded that a weaker growth outlook and higher interest payments on debt mean Hunt has less room to manoeuvre than it thought at the time of November’s autumn statement

Now the debate over what the government should do is in a lather because of the diminished ‘fiscal headroom’ estimates.

I have to stay calm when I read all this nonsense.

There are several problems with the whole fiscal framework approach that governments use these days.

First, think about the starting assumptions – that include the view that governments:

1. Should issue public debt to match their net spending – which, of course, is not a financial necessity at all. The government could do away with the entire gilt issuing process and the net spending would still occur as it does today.

The reality, that most people miss, is that the issuing of gilts is just an example of corporate welfare disguised as ‘funding’ the deficit.

The deficit does not need to be funded – it just happens as a consequence of currency-issuing capacity of the government.

The bonds that are issued provide a risk-free asset to the financial market speculators which they use to bolster their profitability.

Corporate welfare.

2. Even if the government persisted with the debt-issuance chimera – they know full well that they can control the ‘costs of borrowing’ whenever they like, including forcing the financial markets to take negative yields.

I am not suggesting they should do the latter, but the reality is that the central bank (a part of government) – can control yields on government debt whenever it wants and the financial markets only get to influence the yields if the government allows them to.

So the ‘poor government at the behest of the markets’ narrative, which underpins the ‘fiscal headroom’ story deliberately avoids that reality.

If there were pressing matters that needed large government investment, for example, climate change, then the government could spend as much as was required and still issue debt at zero yields if it so desired.

Second, the relevant fiscal space cannot be meaningfully defined in terms of financial outcomes.

What defines the fiscal space is the available productive resources that can be utilised to fulfill government policy objectives such as low unemployment, better housing, improved public health, transport and education, and climate solutions.

At present, my assessment is that the objectives in the British context (that I would define and I think anyone would desire) require net public spending that is well in excess of the available productive resources.

So my estimation of fiscal space is low but based on a totally different logic to that used by the OBR and mainstream economists.

According to my approach, it is likely that the government will have to increase taxes to meet the legitimate objectives.

Now a new reader might say – I thought Modern Monetary Theory (MMT) indicates that taxes do not fund government spending.

Indeed it does.

So why would I say taxes might have to rise?

I say that because while taxes serve many functions, a major function is to free up resource usage in the non-government sector so that the government can spend into that sector and bring idle productive resources in productive use without introducing demand-pull inflationary pressures.

Taxes deprive households, for example, of spending capacity and thus in a situation where all the available productive resources are being full utilised, rising taxes can reduce that utilisation (create ‘unemployment’) which then provides government with the scope to command those resources through public spending and provide public infrastructure and services.

One function that taxes do not perform, is to provide the British government with more pounds that allow it to spend.

Conclusion

Sadly, the debate in Britain is conducted on this flawed basis and the outcomes are commensurately inferior.

That is enough for today!

(c) Copyright 2024 William Mitchell. All Rights Reserved.