Debt is high and the public finances are in poor shape. Yet it looks set to be a borrow, tax and spend Budget, with increased borrowing to fund public investment, and higher taxes to pay for more government spending.
The Budget is also expected to unveil a significant change in the target measure for the public finances. Currently, we look at these in terms of debt and liabilities, with targets announced for Public Sector Net Debt (PSND). A change to the balance sheet definition of debt is expected, which includes assets as well as liabilities.
Enthusiasm for this is based on the view that public investment is low and that you should take note of the asset created. I examined this in May last year and took a positive view of the change as it should focus greater attention on public expenditure.
A switch is expected from PSND to Public Sector Net Worth (PSNW), which includes financial and non-financial assets and liabilities. This is more than just a technical change. For a start, it could transform the Chancellor’s options in the Budget. Moving to PSNW may allow around £50 billion of fiscal space. It could also trigger a new fiscal rule: a net worth objective to improve as a share of GDP over time.
In August 2024, PSND was £2.77 trillion, or 100% of GDP. On a narrower definition, PSND ex, which excludes the Bank of England was £2.55trn or 92% of GDP. Looking at PSNW the figures are far less, as three quarters of liabilities are offset by an asset. In August, PSNW was minus £727bn but even this has deteriorated over the last year, by £119.8bn, as liabilities rose more than assets.
While investment creates an asset, you still have to finance the liability. A balance sheet approach doesn’t get away from the need to fund the deficit and keep investors and financial markets on side. So, there is a need for openness, transparency and fiscal prudence.
One key is to fund the infrastructure cheaply. The UK missed the opportunity in 2012-13 and after the pandemic to lock into cheap longer-term borrowing to fund necessary infrastructure. Future decisions must be mindful of market conditions.
Another key factor is making the right investment choice. Public investment should raise growth to improve living standards and lower debt to GDP ratios. The OBR recently said a permanent rise of 1% of GDP in public investment raises growth by 2% after 10-15 years. Trouble is, the returns are highest for illiquid assets such as schools or roads and also take time, and this is not captured by our current debt-based fiscal rules.
Boosting the supply side of the economy is essential for future growth. Infrastructure will play a key role here. There are areas where the public sector can make a difference, by borrowing cheaply and investing longer-term in capital-intensive projects – in the green transition, say.
However, the UK’s track record on public investment is not good: we have a long history of poor decisions delayed by planning controls and a host of consultations and regulations. Hence easing planning reform and regulations is critical to make execution quicker and cheaper.
Equally, changing the institutional mindset is important as some investment projects have been held back because of excessive Treasury caution with budgetary worries dominating growth opportunities.
But a hit and miss approach is likely in the future, as public investment projects can differ greatly. They take time to see if they work and if too high a rate of return is assumed, then optimism about the project may prove misplaced. Linked to this is that we are now a service-dominated economy, and much of this public spending may be in areas where we lack workers with the technical skills or firms at home to deliver the contracts.
Although much of the present debate is about how this will allow scope for higher public investment, it could – with the right focus – be a stepping stone towards a greater focus on improving the quality as well as controlling the quantity of public sector expenditure.
A focus on the balance sheet provides fiscal conservatives with the opportunity to transform the policy debate and change the way national debt is assessed.
Government must focus on where investments can make an impact. Other countries like France and Germany have a far higher capital stock than us but their economic prospects are no better.
It’s important the public sector doesn’t try to do it all. Ideally, addressing the UK’s low rate of investment should include incentivising the private sector and requires the City to pull its weight in closing funding gaps.
A balance sheet approach allows a comprehensive assessment of the Government’s finances. This includes examining the high public costs associated with public-private partnerships or large unfunded future pension liabilities.
Looking at assets can be misleading, as a government may find it hard to sell many of its assets if it wanted to. This should be priced into the balance sheet. Some assets will have a high price, others will have no price as there will be no buyers. A focus on PSNW could mean a government may decide – and find it easier – to sell assets in the future. Ideally, this would prevent decisions that are short-term and transactional – say, selling buildings to raise revenues to balance budgets – rather than strategic.
Also, the distinction between public investment and current consumption is nuanced. In a mature economy like the UK’s, the highest returns may be in smaller projects, which are often cut, as we saw in the first weeks of this Government. Or in maintaining the existing capital stock, which counts as current spending. It should also be noted that investment in a public asset like a hospital or a school needs higher associated current spending on doctors and teachers.
Some suggest it might make it easier to justify the case for nationalisation, since the cost of acquiring would be balanced by an asset being created. But the high cost of taking assets back into public hands might suggest otherwise.
Moving to a balance sheet approach could help create a more effective public sector, thus limiting the size of the state, not a justification for ever higher spending funded by rising taxes or increased borrowing.
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