The UK’s fiscal problems aren’t just about growth

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is the Gregory and Ania Coffey Professor of Economics at Harvard University and formerly First Deputy Managing Director and Chief Economist of the IMF

The United Kingdom has a fiscal problem, and it is not (only) what you think it is. Much of the debate focuses on sluggish growth and high debt, but there is another issue — one that policymakers can fix far more quickly: excessive fiscal policy uncertainty.

An important driver of this is the repeated assessments of fiscal “headroom” by the Office for Budget Responsibility and the expectation — by markets, commentators and politicians — that any projected gap five years out must be closed immediately through tax rises or spending cuts. This cycle creates unnecessary policy uncertainty and market instability which has been shown to be costly, significantly reducing industrial production, tightening financial conditions and weakening sterling.

As chief economist of the IMF, I oversaw global growth projections. I value the information they provide, but I would be wary of treating any five-year forecast as precise. Economic projections are inherently uncertain. To then reassess taxes and spending every six months based on these long-range estimates introduces volatility into fiscal policy, volatility that markets can amplify.

This is not a critique of the OBR. The OBR plays a vital role in ensuring transparency and compliance with fiscal rules. The problem lies in the unintended consequences of too frequent assessments. Twice-yearly evaluations of fiscal headroom have meant twice-yearly budgets in the UK.

The IMF points out that international best practice offers a better way. Most advanced economies conduct a single annual assessment of compliance with fiscal rules. Budgets are set once a year, not twice. This reduces noise and allows governments to focus on medium-term planning rather than short-term firefighting. The UK should consider following suit.

Specifically, it could eliminate the spring OBR assessment of fiscal headroom. Economic projections in the spring could continue as they are essential for informed debate, but they should not trigger a formal compliance review.

Building off of a paper for the American Economic Association, Gee Hee Hong and co-authors find that having a single annual budget for the UK can raise industrial production on an annual basis by 0.3 per cent (around £1.5bn) and strengthen the sterling by 0.5 per cent. It helps to note that £1.5bn is around 15 per cent of the average fiscal headroom over the past few years.

None of this diminishes the importance of fiscal discipline and growth enhancing reforms. The UK faces real challenges: weak growth, high debt and demographic pressures. Public sector net debt stood at approximately £2.8tn at the end of the last fiscal year, or about 94 per cent of GDP, close to the highest level since the mid 1970s. The IMF projects UK GDP growth at 1.3 per cent for this year and next, a consequence of several years of slowing productivity growth.

These figures underscore the need for credible fiscal policy, but credibility should not come at the cost of elevated fiscal policy uncertainty.

In short, UK fiscal policy does not just have a growth problem; it has an excessive fiscal uncertainty problem. Fixing the latter will not solve the former, but it will create the space and stability needed to tackle it.

Chancellor Rachel Reeves, in a reference to the November 26 Budget, said last week that, “Each of us must do our bit.” The fiscal framework in the UK can do its bit by moving to one annual assessment of rules, and one Budget cycle.