Unleashing growth in the UK: time to break the fiscal chains

Dimitri Zenghelis outlines what a smarter fiscal strategy for Britain would look like – one that eschews austerity and champions investment in intelligent, sustainable and resilient growth.

This time last year, together with a group of economists, I wrote an LSE/Cambridge University report outlining the clear link between UK underinvestment – both public and private – and the country’s poor productivity performance since the 1990s. We argued that basing fiscal targets on borrowing and debt liabilities, while making no distinction between investment and day-to-day spending, effectively disregarding the health of the asset side of the public balance sheet, was a recipe for protracted economic stagnation. We called for a change in the fiscal rules.

The fiscal tail must stop wagging the growth dog

For over a decade, successive governments have been stuck in a doom loop where cutting public investment to meet fiscal austerity ambitions undermines growth and erodes net fiscal revenues, prompting a further round of cuts. We presented historical evidence showing that countries grow, not cut, their way out of debt problems.

We also highlighted another problem: the UK’s chronic savings deficiency. Without offsetting measures to rein in consumption, more public investment would simply push up inflation, prompting the Bank of England to hike interest rates, choking off private sector investment –the very thing we need to induce.

We concluded that the Government needed a growth strategy focussing on investment in clean, resilient assets that bolster the UK’s competitive advantage in growing markets. These investments would be self-sustaining, generating strong returns, and lowering debt/GDP through favourable impacts on the numerator and denominator. By investing in efficient, intelligent and innovative technologies, these measures would also contribute to the achievement of the country’s net zero target.

Extra investment needs macroeconomic space

Two of my co-authors, Anna Valero and John Van Reenen, now formally advise the Chancellor, and the October 2024 Budget adjusted the fiscal rules to refocus policy on investment in productive assets. This welcome and major step forward will boost the UK’s long-term productivity growth by creating long run space for necessary public investment. But unfortunately, the budget failed to create corresponding short run space.

This is a macroeconomic issue. A budget that raises demand in an economy operating close to capacity – without addressing the inflationary implications – only ends up raising interest rates. Ruling out increases in taxes which bring in nearly 75 per cent of revenue made this a near inevitability. Predictably, bond markets reacted. Forward rates rose on the day of the Budget, anticipating higher-for-longer interest rates from the Bank. The Office for Budget Responsibility actually cut its forecast for UK GDP in 2029 by 0.2%, citing the Budget’s impact on crowding out private investment. Business confidence slumped, and with it, private investment prospects.

Flexibility on taxes and borrowing required

To crowd in investment, the Government needs to boost business sentiment and crowd out consumption. Household taxation, in particular VAT and duties, would be the obvious instruments, especially where they target activities we seek to discourage like pollution and waste, together with measures to offset any regressive distributional consequences.

At the same time, a stagnant economy has meant the public finances are not improving as expected. Just months after the Budget, the Government risks missing meeting its own fiscal rules – while also committing to spend an extra £6 billion a year to meet it’s 2.5% of GDP target for defence spending by spring 2027. This has prompted talk of deep cuts in the spending review.

The economy’s enduring weakness may yet generate the precautionary savings needed for the Government to boost investment without inflation – if households and businesses spend less, the Bank won’t need to hike rates. But this is doing things the hard way. It relies on businesses and households anticipating hard times and tightening their belts – hardly a recipe for a sustained rebound in confidence and animal spirits. Yet cutting spending again to meet the fiscal rules would be precisely the wrong response. So what should the Government do? 

Fiscal rules need another important tweak

The Government must amend the fiscal rule that requires a balanced ‘current’ budget. Right now, this is defined in terms of ‘day-to-day spending’ funded by tax revenues. But this rule should be applied over the cycle, allowing fiscal flexibility to respond to unexpected economic shifts.

When the economy slows down, tax revenues fall while the benefits bill rises. That creates temporary government borrowing through the so-called ‘automatic stabilisers’. But the economy also requires additional discretionary public borrowing to prevent a prolonged downturn. Failing to borrow now would only worsen the long-run fiscal position.

The markets care about growth, not debt

Contrary to unhelpful political messaging, the financial markets are not panicking about UK sovereign debt. The UK borrows in its own currency, has a wealthy taxpayer base, and is not a fiscal or public debt outlier in the G7. It is a growth and inflation outlier.  What the markets fear is enduring low growth and stagflation. This keeps policy rates high and erodes the real value of UK bonds. If the Government presents a credible plan to boost growth sustainably, investors will welcome it (this is not another Truss-Kwarteng experiment).

A fiscal strategy for growth

The Government cannot afford to work backwards from budget arithmetic letting fiscal rules dictate its growth strategy. It must:

• Make the case for a sustainable growth strategy – backed by clear and well-thought out fiscal rules, and a credible commitment to borrow for public net investment.
• Recognise that the reality on defence requires a recasting of past approaches to the fiscal strategy and inevitably means more in taxation to come.
• Focus investment on key infrastructure and on the technologies of 21st century, including AI, clean electricity and transport. The National Wealth Fund has role to play here, with equity and guarantees reducing the private sector cost of capital.
• Adjust the current budget rule to enable taxing consumption where slippage is structural, but not cyclical.

Provided the investment is subject to tough criteria and moves quickly, growth is the surest strategy for fiscal credibility. It would allow the Government to hold its commitment to one fiscal event per year, while still making space to invest in the UK’s future. If it does this, it may yet fight the next election on a platform of having delivered the growth the country sorely needs.

The author was formerly Head of Economic Forecasting at HM Treasury.