Can Rachel Reeves boost public investment and keep the markets onside?

There are only two more Sundays to go after this until the October 30 budget, which makes it sound a bit too much like Christmas, and debates are raging on several fronts. Many are about tax but also whether, after a rocky start, the government can generate some growth optimism and make a reality of what a spokesman said a few days ago would be “the most pro-growth Treasury in history”.
Tomorrow’s international investment summit and the long-awaited launch of the government’s industrial strategy might help, but it would be unwise to expect miracles.
Among economists, the big debate is over how — given a fiscal inheritance she has complained loudly about — Rachel Reeves can make room for the public investment that Labour sees as essential to its growth mission. Yes, readers, we are into the realm of the fiscal rules, and in case you find this as off-putting as football fans find VAR, bear with me.
The big picture is that public sector debt has hit 100 per cent of gross domestic product, its highest level relative to GDP since the early 1960s, when it was still on its way down after the Second World War.
The context, set out by the Office for Budget Responsibility (OBR) in the March budget, is that despite a rise in the tax burden to record levels, and plans envisaging a freeze in real spending per person on public services, the fiscal rule of reducing the ratio of public debt to GDP in five years’ time would only be met by “a historically modest margin” of less than £9 billion.
The other context is that the Institute for Fiscal Studies (IFS) has published its annual Green Budget, so-called not because it is anything to do with the environment, but because — in a nod to green papers, consultation documents produced by the government — it sets out the possibilities for October 30 and beyond. The IFS’s very useful 345-page report goes into the detail of things that I planned to write about this week.
That Treasury “pro-growth” statement was in response to the Green Budget, or what it described as the Green Book, which I think is something different. It also committed the chancellor to “the robust fiscal rules set out in the [Labour Party election] manifesto”.
Let me remind you of those “non-negotiable” fiscal rules. The first was that “the current budget moves into balance, so that day-to-day costs are met by revenues”. The government can borrow but only to invest — a revival of Gordon Brown’s “golden rule” when he was Labour chancellor.
When the OBR published its last forecast in March to accompany the Conservative government’s final budget, it expected that rule to be met by 2027-28 — but only on spending figures that its chairman, Richard Hughes, said it would be generous to describe as a work of fiction.
Slotting in more realistic plans — to cover the fact that, for example, higher inflation has required bigger increases in public sector pay and other costs, and to avoid a repeat of the austerity of the 2010s — is where the IFS gets its figure for £25 billion of tax hikes being needed in this month’s budget.
That is more than the £15 billion to £20 billion of “new” taxes I expected, but includes £9 billion of tax hikes set out in Labour’s manifesto but not yet implemented. Those, which include VAT on private school fees, increased taxes on private equity “carried interest”, revenue from non-doms and a further clampdown on tax avoidance, are contentious — both in terms of the measures themselves and the revenue likely to be raised, where there are discrepancies between Treasury costings and those of Labour when in opposition.
Of the remaining £15 billion-£20 billion, an increase in employers’ national insurance, possibly by levying it on firms’ contributions to employee pension schemes, looks to be a frontrunner. There are other contenders.
It is, though, Labour’s second fiscal rule where the debate has been raging most. This was that “debt must be falling as a share of the economy by the fifth year of the forecast”. It seemed that the new government would inherit the Conservatives’ exact debt rule, and Reeves gave that impression.
The trouble is that unless she has even more tax rises up her sleeve, there would be no room for the public investment that Labour has flagged and regards as necessary to generate stronger growth. Many others share that aspiration: Mark Carney, the former Bank of England governor, and Lord (Peter) Mandelson, a leading light in the last Labour government, have added their voices to calls for the chancellor to make room for a substantial increase in investment. Darren Jones, the Treasury chief secretary, has announced that next year’s detailed spending review will include a ten-year infrastructure strategy.
This is where it gets tricky for those not into the nitty-gritty of the public finances. The debt measure used by the Tories most recently — and remember: the fiscal rules have changed regularly over the past decade and a half — was public sector debt excluding the Bank of England. It is a tough measure that, as noted above, leaves next to nothing for boosting public investment.
The easiest change the chancellor could make would be to shift to overall public sector net debt, thus including the Bank. This, commonly used until recently, has a more favourable profile. In March, the OBR saw it peaking this year relative to GDP and then heading downwards and releasing an additional £16 billion for investment.
Two other measures are also in the frame, both of which provide even more room for manoeuvre. These are public sector net worth (providing additional fiscal headroom of £58 billion, according to the IFS), and public sector net financial liabilities, known to fiscal nerds as “Persnuffle”, which would offer £53 billion of extra headroom. This is because both measures take into account government assets as well as liabilities.
There are three problems with all this. Changing the debt measure, even for a good reason, looks like moving the fiscal goalposts. Public sector debt has the merit of being easier to understand and measure. Public sector net worth and “Persnuffle” are published each month by the Office for National Statistics but suffer from greater measurement uncertainties and, if anything, provide too much room for manoeuvre.
A second problem is that any debt target that has it falling in the fifth year of the forecast is fundamentally flawed. It is a moving target that, in practice, is very often missed and encourages chancellors to game it. Controlling debt should be an important constraint, but a rolling five-year target does not do it effectively.
Then there are the markets. UK ten-year gilt yields — the cost of government borrowing — are now higher than those in America, and significantly higher than in France, Germany, Italy and even Greece.
This is not yet a reflection of market worries about how much more borrowing will be unveiled in the budget, but rather a fear that inflation and interest rates will be slower to fall than hoped, despite recent dovish comments from Andrew Bailey, the Bank governor.
But the rise in the cost of borrowing is a warning that, while policymakers are clear on the need for more public investment, as are most economists, the chancellor has yet to take the markets with her. A budget process that has dragged on and sown a lot of uncertainty has a lot to answer for. As well as ending that uncertainty, Reeves will want a favourable reaction from the financial markets. This is not yet guaranteed.
PS
There is a lot of this budget edginess around, and it has depressed confidence. Among the people with the “broadest shoulders” who may be facing higher taxes are those in the private equity industry. Indeed, there has been talk of an exodus among its big players.
A few days ago, I attended and contributed to the annual economic update run by CIL, a consultancy firm where many of its clients are indeed in the private equity business.
CIL released the results of the annual Investment 360 survey that it conducts, with about half the respondents from private equity. The findings, perhaps surprisingly, were generally positive on both the short and longer-term outlooks for the UK economy, and the investment climate.
The survey’s biggest ask from the new government is that it provides a period of economic and political stability, followed by closer economic relations with the EU. But lest the chancellor thinks that this gives a green light to whack businesses and investors with big tax rises, it also suggested that while some increase in taxes looks inevitable, it should be balanced and proportionate.
The CIL’s research shows a hunger for the Bank of England to cut interest rates more rapidly than it is doing, but criticism of the Bank — too slow to raise rates, too slow to bring them down — is more muted than in recent years. Surprisingly mellow on all fronts.
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