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An assessment of the UK's fiscal framework and the case for reform

The UK fiscal framework is based around a set of pass–fail fiscal rules, which require some measure of borrowing or debt to be below a particular threshold in a specified year. There is no such thing as a perfect framework, and this one has some desirable features. But the UK’s fiscal debate has come to be completely fixated on the amount of ‘headroom’ against those fiscal rules, and this fixation is increasingly contributing to a dysfunctional policymaking process. Meanwhile, aggressive ‘gaming’ of rolling targets and frequent changes to the rules have undermined their credibility. Nor is the framework delivering on its promise of sustainable public finances. 

New research from the Institute for Fiscal Studies, published yesterday and funded by the Joseph Rowntree Foundation, argues that the UK’s approach to fiscal policy needs a rethink. It argues that in place of pass–fail fiscal rules, the UK would be better served by a new framework based around a set of ‘fiscal traffic lights’, used to monitor performance against high-level fiscal objectives and principles set out in a Statement of Fiscal Strategy at the start of each parliament. This would seek to address shortcomings of the existing system and improve the incentives facing policymakers, while maintaining fiscal discipline and credibility with financial markets. The report sets out details of how this could work in practice. 

Importantly, this is not an argument for immediate reform, or for any sort of announcement at the upcoming Spring Forecast: these proposed reforms should only be made from a position of strength. Nor is it an argument that the government ought to be running tighter or looser policy. It is an argument that our current fiscal framework is not working as well as it should, and that we should be thinking and debating now, ahead of the next election, about what a credible alternative could look like. This is an attempt to make a concrete contribution to that debate. 

Ben Zaranko, Associate Director at IFS and author of the report, said:

‘The world is complicated, the future is uncertain, and the question of whether the government’s fiscal policy is sustainable or not cannot be boiled down to a single number. Yet that’s what happens under our current framework. Assessing fiscal sustainability based on a pass–fail borrowing rule is a bit like being behind the wheel of a car and judging whether or not you’re driving safely solely by looking at the speedometer, while ignoring the traffic conditions, the weather, and whether or not the brakes are working. 

‘Moving to a broader set of fiscal indicators, assessed according to a traffic light system, would provide a better picture of the government’s overall fiscal position, and reduce the incentive for governments to contort policy in pursuit of a particular “headroom” number. Breaking the obsession with “fiscal headroom” might also provide the basis for a more meaningful debate about the fiscal opportunities and challenges facing the country.’

Helen Miller, Director of IFS, said:

‘It’s important for all our futures that policies are well designed and that the public finances are sustainable, but the UK’s current fiscal framework isn’t delivering on either front. We should be debating how to improve the framework now, rather than waiting for the next set of fiscal rules to be developed in a rush, behind closed doors, after the next general election. A broad traffic light assessment of the public finances would make governments’ multiple objectives – and the associated trade-offs faced – much more transparent and explicit.’ 

Further findings and recommendations of the research include:

• Many problems with the existing framework stem from the combination of having a numerical, pass–fail rule and aiming to meet it almost exactly (with small amounts of so-called ‘headroom’). This means that whenever macroeconomic forecasts move around (as they inevitably do), policy also has to adjust: volatility in the forecasts translates into volatility in policy. This makes for rushed and lower-quality tax and spending policy, and adds to economic uncertainty. 
• Other problems include: the ease with which rolling fiscal targets have been ‘gamed’ by successive governments (by promising future consolidations which never arrive); the heightened incentive to contort policy when everything depends on the value of a particular metric in a particular year; and the unhelpful amount of pressure placed upon the central point estimate of the Office for Budget Responsibility (OBR)’s forecast. 
• Recent moves by the government to modestly increase the amount of ‘headroom’ and to have a single annual assessment of performance against the fiscal rules are an improvement on the previous status quo, but represent an unsatisfactory solution to the underlying problem. For one thing, even if a larger buffer can be maintained in the face of acute spending pressures, the unhelpful concept of ‘headroom’ would remain entrenched at the centre of the fiscal debate and policymaking process: we would just have one ‘headroom’-chasing fiscal event each year rather than two. 
• The first pillar of the proposed alternative framework would be a high-profile speech, called something like a Statement of Fiscal Strategy, held at the start of each parliament and then at regular intervals. This would set out high-level fiscal objectives, expressed in narrative terms as a direction of travel for the parliament, rather than as precise numerical targets with dates attached. This approach would draw from the concept of ‘fiscal standards’ (previously proposed for the European Union) and from the ‘principles of responsible fiscal management’ underpinning the fiscal framework in New Zealand.
• The second pillar would be a set of economic and fiscal indicators (perhaps eight to ten), specified by HM Treasury alongside the Statement of Fiscal Strategy, against which fiscal policy would be assessed and monitored. These would vary depending on the context and the government’s broad objectives, but would in all cases be expected to include measures of borrowing, debt and debt interest, and to be constructed for multiple years of the forecast. 
• At each fiscal event, the OBR would be tasked with producing forecasts for each of these indicators, and describing the outlook for each using a gradated red–amber–green traffic light system (with the definitions of what constitutes red, amber and green provided by HM Treasury, not the OBR, ideally after external consultation), to help communicate the broad fiscal picture in an intuitive and understandable format. These traffic lights would become the centrepiece of the OBR’s assessment at each fiscal event, rather than an estimate of ‘headroom’. 
• Under this approach, there would be less incentive to contort policy based on its treatment under the fiscal rules. And, depending on the indicators chosen, there could be more incentive to address longer-term challenges and issues that are generally ignored by the current framework. It would more explicitly recognise the multiple objectives of fiscal policy. A reformed framework could also help to address the perception that the central point of the OBR forecast is de facto setting government policy. 
• Such an approach would not be without downsides and would undoubtedly create new challenges. The trade-offs involved are discussed at length in the report. Any potential downsides (e.g. less of a guard against politicians’ tendency towards excessive borrowing) would need to be weighed against potential benefits (e.g. a less dysfunctional approach to fiscal policymaking) – the argument in the report is that these are trade-offs worth making. 
• This is not a proposal for reform in the short term: only from a position of strength and well-established credibility should such a change be considered. Ideally, the government would have delivered and sustained a primary surplus and/or current budget surplus before making the move to a traffic light system. In the nearer term, there would be a strong case for running the traffic light process in parallel with the current system for the remainder of this parliament, to iron out issues and build understanding ahead of a full transition at an opportune moment in future. ​

From fiscal rules to fiscal traffic lights: rethinking the UK fiscal framework 

Does the UK fiscal framework need a rethink?