The UK Fiscal Framework Backfires, Leaving US Facing Tax Rises

What is the UK government's new fiscal framework?

In its October 2024 document the government set out what it said was "A strong fiscal framework". This allowed some relaxation in spending on the grounds that more capital spending by the public sector would be important to boost growth. The new rules require the OBR to review any fiscal changes and limit the government to a single fiscal event or budget a year. The rules were set for the whole Parliament.  The government is to work towards no deficit on current spending by 2029-30, and to debt declining as a percentage of GDP by 2029-30 to limit the amount to be borrowed for capital purposes. 

The aims were good. It would be much better if all current spending was paid for out of taxation to avoid transferring the costs of today's services to tomorrow's taxpayers through extra debt. It makes sense to say the government can borrow to invest, as long as the government hits the required target returns to make a profit on the borrowings. It is also prudent to prevent excessive debt even where investments are thought to be advantageous, in case things go wrong. Buyers of the government debt, the lenders to the government, need reassurance that debt will not become excessive. With net debt close to 100% of GDP and with interest charges now costing the government more than £100 bn a year markets are concerned. The cost of longer-term government borrowing is higher in the UK than the US, Japan, China and all the major EU economies. This is seen in part as a penalty rate to warn the government to rein in new debt. 

What are the problems with the new fiscal framework? 

The impression given is by 2029-30 all will be under good financial control, but the small print of the rules allowed otherwise. After two years the rule ceases to say there should be a current balance or surplus by 2029-30 and ceases to say net debt will be falling as a proportion of GDP by 2029-30. Instead, from that point the government has to show in its forecasts that three years hence these conditions will be met. So, under these rules the government could go for the whole of this 5-year Parliament (if it runs to full term) without either getting into current balance or seeing debt reduce as a percentage of GDP. 

The government has also changed the definition of net debt to use a number called Net financial debt. This adds in government equity and loan holdings as an offset to some of the debt, and includes assets held in public sector funded pension funds, whilst also deducting the liabilities.  Net financial debt has tended to be a bit below the net debt figure used for these purposes before, and to be a bit less volatile since the 1990s. 

In her first budget the Chancellor raised extra taxes to deal with her claim that she had inherited £20bn of borrowing outside the rules. She raised public spending by considerably more than £20bn to meet high wage claims from the NHS, railways and others, and boosted planned capital spending. As a result, she left herself little headroom against the more relaxed borrowing controls of her new fiscal rules, setting up difficulties for the second budget if the economy failed to grow faster.

What are the UK government's spending plans? 

Budget 2024 by the incoming government set out the following path for total public spending:

2024-5        £1,276bn

2025-6        £1,335bn

2026-7        £1,379bn

2027-8        £1,418bn

2028-9        £1,461bn

The government gave a big boost to public spending for its first full year, with some high wage awards in the public sector absorbing much of it. The plans then assume a slowdown in spending growth, becoming quite tight in the second half of the Parliament. This is unusual, as governments typically undertake any spending slowdown in the first couple of years and accelerate spending for an election. Markets will be sceptical about how much restraint will be exercised 2027-9. 

The government was keen to announce more investment spending to stimulate or co-fund private sector work. Its separately identified programme sees an increase of £40.1bn for the Parliament, to a total of £137.4bn. This however includes UK Export Finance at £80bn and includes £88bn in the form of guarantees. 

What do the markets think of these changes?

So far markets have pushed up longer term borrowing rates for the government, whilst the Bank of England has brought down the base rate by 1.25%. Shares have been able to make gains, with enthusiasm marked for the sectors which get a spending boost. 

It is generally assumed the Chancellor will be told growth and productivity are less strong than assumed in the last forecast, and that there is a need to cut the future deficit by somewhere between £20bn and £40bn. The Chancellor is likely to prefer doing this by more tax rises than by spending cuts, given the inability to secure the modest sized spending cuts she chose last time. 

UK government bonds offer higher rates compared to EU country bonds and even offer a small advantage over US Treasuries. It is likely the government will increase taxes in the November budget again this year, despite the assurances last time that they had filled in the black hole with the National Insurance hike and other rises. Markets will want the Chancellor to stick to the fiscal rules and will want to see the future deficits coming down. Keeping to the rules of course can be achieved by setting out low figures for 2028-9 spending to offset adverse changes in the official forecasts of growth and revenues. Some will believe that, and others will warn we should expect more spending in the later years.

About the author 

The Rt. Hon Sir John Redwood has been a long-standing member of the EPIC Investment Partners Advisory Board. 

John is a well known commentator on governments and economies, with long experience of investment markets. Trained as an analyst at Robert Flemings, he moved to N.M. Rothschilds where he became a Manager and Director of pension and charitable funds and Head of Equity Research. He was seconded to become Head of the Downing Street Policy unit before chairing a large, quoted UK industrial business. He served as an MP and a government Minister.  

In 2007 he set up Pan Asset with a colleague, an investment management business that pioneered active/passive funds and models in the UK. Following the sale of the business to Charles Stanley, a quoted investment manager in the City, he became their Global Chief Strategist advising on non-UK markets and economies. He also ran a demonstration fund for the FT, writing articles about it and illustrating the use that can be made of ETFs in portfolios. 

He is now an adviser to EPIC, providing insights into the big investment issues of the day from the debt and spending problems of the major governments to the green and digital revolutions which have so much impact on equity markets. He is a Distinguished Fellow of All Souls College, Oxford, where he helps with their Endowment investments and gives occasional lectures on modern economics and politics.