Is John Healey crowding out private infrastructure?

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This morning, John Healey delivered his first major speech as Chancellor. He set out his vision for the economy and, while it was encouraging to hear his determination to drive growth and solve the NEET crisis, all while claiming to be committed to fiscal discipline, it was quite light on detail.

However, one specific point he did mention was incredibly significant but likely to be overlooked by the media: his decision to lower the Green Book’s Social Time Preference Rate from 3.5% to 3%. This is essentially the discount rate which HM Treasury uses to weigh up whether or not new infrastructure is worth it. This might sound like a dry accounting detail but it really matters. This is the mechanism that decides how much public money gets committed, how it’s financed and who ultimately ends up footing the bill. 

When officials at the Treasury conduct a cost-benefit analysis, they have to compare money spent today against benefits that might not arrive for decades. The discount rate is how this comparison gets made. However, it would be wrong to think of the rate as some arbitrary dial for expressing how patient the mandarins feel. Instead, it’s meant to reflect the opportunity cost of capital: what else that money could have earned, or achieved, had it stayed in the hands of the households and firms who would otherwise have spent, saved or invested it.

At 3.5%, a benefit 50 years out is worth a certain percentage of its face value today. Cut the rate to 3%, and that same benefit increases significantly even though nothing about the proposed project has actually changed and they still cost the same to build. What has changed is how generously the state values tying up capital in a project versus leaving that capital to do something else. A lower discount rate implicitly assumes the return available elsewhere in the economy such as in private investment, paying down debt or a tax cut that lets households and firms make their own capital allocation decisions is worth less than it used to be. 

There is also a real danger here of the private sector being crowded out. Every pound the state borrows or spends on a marginal public project is a pound that isn’t available to fund a marginal private one. Whether that’s through the government competing for the same pool of savings, gilt issuance pushing up the cost or simply the state occupying construction capacity, engineering firms and skilled labour that a private developer might otherwise have hired. This gets even worse when the discount rate falls, because a lower rate mechanically waves through more marginal projects. As a result, schemes that were sitting just below the old threshold and are now judged ‘worth it’.

The private sector on the other hand doesn’t get to appraise its own investments with a discount rate chosen by government fiat. A private developer weighing up a warehouse, a factory extension or a housing development has to use a rate that reflects their actual cost of capital and the real risk of the project (often far higher than 3%). If the state is now appraising its own long-horizon projects more generously than the market appraises equivalent private ones, public capital starts winning out over private capital not because it’s more productive, but because the government has changed its own scorecard. That is simply not an efficient allocation of scarce resources. Instead it’s the state outbidding the market by changing the rules of the game.

There are also serious implications for the public finances. A lower discount rate approving more capital projects doesn’t make those projects free. It simply means more borrowing to fund them. The Chancellor is right to point to the importance of fiscal discipline but lowering the discount rate undermines his stated commitment. For example, if projects start getting waved through on the strength of benefits discounted at 3% rather than 3.5%, and even a fraction of them run over budget or under-deliver (as major UK infrastructure schemes routinely have) then it is the state that is left holding debt raised against benefits that a more conservative appraisal would never have signed off on in the first place. 

While high gilt yields are a global issue, the UK is in a particularly vulnerable position. This is for a number of reasons but it is at least partly due to investors being concerned about the country’s national debt – a point which the Chancellor himself made today – and their doubts about the government’s willingness or ability to cut public spending. Lowering the discount rate risks further undermining investor confidence and increasing borrowing costs for the government, households, and firms.

Moreover, the awkward truth about a lower discount rate is that it shifts the balance of who bears the cost of a project versus who enjoys the benefit. Costs are almost always front-loaded while benefits are, by construction, stretched out over decades. A lower discount rate makes it easier to justify committing today’s borrowing, and therefore today’s debt service and today’s tax burden, against benefits that a future generation will enjoy and a future government will have to hope actually show up.

Current taxpayers service the debt from day one. They don’t get a vote on whether the benefit, arriving in year 40, is worth what the appraisal said it would be. If growth disappoints, if the scheme is later mothballed, or if the promised regional economic uplift simply doesn’t happen at the scale forecast, it’s this decade’s taxpayers who financed a bet that this decade’s Green Book made more attractive to take.

While it is important to build infrastructure and to provide benefits for our children and grandchildren, this has to be done in a sustainable way. It is also important to be clear about what we mean by ‘infrastructure’. New roads, railways and bridges are what most people think of – and there is a case to be made that these can boost growth and should pass a cost-benefit analysis. 

The danger though is that the government has a much looser definition of infrastructure. A new school or hospital for example which, while no doubt a good thing, doesn’t deliver the same economic boost. Perhaps even more worrying are the views of the people who are advising the Prime Minister and Chancellor. The influential economist Mariana Mazzucato has argued that the Notting Hill Carnival should be viewed as infrastructure and so receive more government funding. This would previously have been laughed out of the door of the Treasury; cutting the discount rate means it might now have to be taken seriously. There is a very real risk that the country will end up being burdened with a herd of white elephants, with taxpayers stuck with the bill.

It’s good to see the Chancellor’s ambition to get the country building. However, this should be done by lowering the tax and regulatory burden on the private sector rather than tinkering with the Green Book.

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