Fiscal policy’s main objectives are now seen as:

• maintaining sound finances over the medium term
• ensuring that spending and taxation decisions have an equitable impact both over successive generations and within generations
• providing support for monetary policy in the short term, through the use of automatic stabilisers and/or changes in fiscal stance. The aim is to provide stability which in turn will help the Government in its quest for high but sustainable levels of growth and employment

The Code, among other considerations, sets out the five principles which will be used to guide fiscal policy, namely, transparency, stability, responsibility, fairness and efficiency.

The Code also requires the publication of four annual documents:

A Pre-Budget Report (PBR)

To be published at least three months before the Budget.

The PBR will normally be produced in November and will contain a progress report on current plans, updated forecasts for the economy and for the public finances as well as setting out measures which are being considered as part of the forthcoming Budget and are open for consultation. By providing an opportunity for consultation and through its forecasts for the economy and for public finances, the PBR is designed to increase transparency.

The Financial Statement and Budget Report (FSBR)

To be published at the time of the Budget. The FSBR will contain details of the measures proposed in the Budget, a summary of the economic environment in which the Budget is framed and details of the fiscal position.

An Economic and Fiscal Strategy Report (EFSR)

To be published at the same time as the FSBR. The objective of the EFSR is to present the Government’s economic and fiscal strategy and objectives.

A Debt Management Report (DMR)

Which reviews debt management issues over the past financial year and sets out the Government’s funding programme over the coming year.

Soon after taking office in 1997, Chancellor Gordon Brown, anxious to demonstrate that this was a prudent and not a tax-and-spend Labour government of old, introduced two fiscal rules to guide the authorities in maintaining fiscal prudence over the course of a cycle as well as providing a measure of how well the Government meets the principles by which it has agreed to abide.

The rationale for this approach was to take into account the effect of the cycle on public finances and avoid the situation which occurred in the late 1980s.

At that time, the improvement in public finances was seen as a structural change rather than a cyclical phenomenon and the subsequent fiscal loosening was badly timed for an economy already growing too strongly.

The Golden Rule

The golden rule stated that over the course of an economic cycle, the Government would borrow only for investment purposes.

Current spending would not be funded by borrowing over the period as a whole. In other words, the Government would aim for the current budget to be in balance or in surplus over the economic cycle as a whole.

The Golden Rule has gone through a number of modifications since its introduction. These have included a change in the way surpluses and deficits are measured as well as a series of alterations to the length of the cycle.

The latest such change was announced in a paper accompanying the December 2006 Pre-Budget Report – it was not mentioned in the Chancellor’s speech to the House – which stated that the first cycle to fall under the aegis of the Golden Rule was estimated to have started in 1997/98 and to end early in 2007. And, luckily, the Golden Rule was met in this definition of the cycle.

The fact that the Golden Rule was in its fifth re-incarnation at this stage doubtless reduced its value in the eyes of many commentators.

It was claimed that Mr Brown was a student marking his own exam paper until he got the mark he needed. What point critics argued was there in a rule which appeared to change every time there was some uncertainty about whether it would be met?

Any lingering claim by the Treasury that the Golden Rule was being met was swept away by the recession and Mr Darling’s 2009 Budget in which he estimated the deficit on the current budget in fiscal year 2009-10 at £132 billion and net borrowing at £175 billion.

The recession had hurt both sides of the government’s accounts. As activity slowed, tax receipts from all the major sources (income tax, VAT, corporation tax, stamp duty, etc.) weakened while spending rose. The Golden Rule has now been consigned to the history books.

The sustainable investment rule

The sustainable investment rule stated that the ratio of public sector net debt to gross domestic product was to be maintained at a stable and prudent level over the economic cycle.

A prudent level, it was suggested, would be below 40%. This would ensure that the cost of investment was borne principally by those benefiting from it, and not foisted on future generations.

Both the Pre-Budget Report and the actual Budget in the decade following their introduction were presented in terms of these two Rules, together with a number of associated ratios which related the public finances to the economy as a whole.

The Sustainable Investment Rule looks to have been achieved more comfortably than the Golden Rule in that period, given that the latter has been subject to a series of re-definitions but the definition of what should be included in public sector debt has been a matter of some debate.

What should be included in public sector debt?

Although apparently less controversial and met with something to spare, the sustainable investment rule can be interpreted in more than one way. It all depends on exactly what is included in the definition of public sector debt.

The use of Private Finance Initiative (PFI) or Public-Private Partnership (PPP) schemes, for example, to finance projects such as new schools, hospitals or roads, is an obvious grey area. The government’s obligations arising from these activities were previously ‘off-balance sheet’, but have now been redefined and included in public sector debt.

The recession, moreover, led to changes in the rules as the supply of private funding came under pressure. In March 2009, the Treasury set up an Infrastructure Finance Unit with a mandate to ensure the continuation of PFI projects. In April 2009, for instance, the Unit provided £120 million of public money to ensure that a waste disposal project in Manchester went ahead and the following month £30 million was made available to support a £700 million waste treatment plant in Wakefield. This clearly adds to the extent of public sector debt.

In September 2006, the Office for National Statistics estimated that total ‘finance lease liability’ at the end of March 2006 was £4.95 billion, some 85% of which relates to PFI/PPP projects.

This would have added 0.4 percentage points to the estimate of public sector net debt as a share of GDP, but thanks to a simultaneous revision to GDP data, the upshot was an increase of only 0.1 percentage points.

Some commentators argue that the Government-guaranteed debt of Network Rail (£18 billion, equivalent to 2 percentage points of the ratio) should also be included.

This is currently not the case, on the grounds that Network Rail is technically still a private company.

Even more contentious is the treatment of public sector pensions. Unofficial estimates of the ‘black hole’ (as it would be called in private sector schemes) range from £500 billion – which would more than double the debt/GDP – to £1 trillion.

The ONS is currently considering if and how this huge liability should be included in the national accounts while government ministers are considering revisions to pension schemes that are far more generous (and costly) than most available in the private sector.

In any case the damage done to the public finances by the recession has meant that net debt has moved to upwards of 50% of GDP for the first time in over 30 years and well above the 40% prudent level set by the Chancellor back in 1997.

Comprehensive Spending Reviews

As part of its changes to the fiscal framework, the current Government also introduced a new way of planning and controlling public spending.

The Comprehensive Spending Review (CSR), published in 1998, set out these reforms, providing a thorough examination of public spending and setting out its path over the following decade. It also included detailed spending plans for the following three financial years, to 2001-02.

Documents published in 2000, 2002 and 2004, called Spending Reviews, built on the CRS, while extending the detailed forecasts to 2003-04, 2005-06 and then 2007-08, respectively.

In July 2005, the Government announced a second Comprehensive Spending Review to report in 2007. This would analyse the outcome of the first CSR as well as setting the groundwork for the pattern and content of public sector spending over the next decade. In the event the 2007 was combined with the Pre-Budget Report for that year.

The next Review will not take place until after the 2010 General Election and will need to take into account the deterioration in the public finances which have occurred over the last year or so.

The Spending framework

The spending framework now in place is conducted through Departmental Expenditure Limits (DEL) and Annually Managed Expenditure (AME) which together add to Total Managed Expenditure (TME).

Three-year plans are set for the major government departments via DEL with AME covering those areas of expenditure which can only be managed on an annual basis.

AME includes expenditure such as social security and debt interest, types of spending which are subject to short term variation and, therefore, difficult to control over the whole three-year planning horizon. AME and DEL each cover around a half of total expenditure. Within TME departments have to run their current and investment budgets separately.

The limits are in cash terms, which means that departments will be under pressure to control costs. They may be reviewed, however, if inflation is markedly different from expected levels thus excessively squeezing real growth in spending.

The new regime is also more flexible in terms of departments being able to carry over unspent monies into the next year.

To improve the value achieved from public monies, each Department has to sign up to Public Service Agreement (PSA). These covenants commit departments to achieving a specific agreed target to improve efficiency.

A Treasury discussion paper, Fiscal stabilisation and EMU, was issued in June 2003. The paper was one of eighteen prepared as part of the Government’s assessment of the five tests for joining the Single Currency.

It was written on the basis that “the degree of fiscal stabilisation may need to increase inside EMU where the absence of a UK-specific monetary policy may cause the degree of macroeconomic volatility to increase.”

The recession has put this on the back burner as the UK loosened fiscal policy to a greater extent than most of the major European economies.

A sustained period of economic growth in the 1990s and into the new decade meant that unemployment fell sharply and with it payments of unemployment benefit.

Increased employment and prosperity, in turn, increased tax revenues commensurately. In addition, lower interest rates reduced debt repayments while Governments sought to control public sector expenditure.

As a result, current expenditure as a percentage of GDP drifted downwards through the 1990s while current revenue as a percentage of GDP increased.

In turn, the current account deficit which peaked in 1993 in the aftermath of 1990-1991 recession slowly fell and between 1998 and 2002, the public sector current account was in surplus (see chart 4.5).

Following the 2001 election, Chancellor Gordon Brown stepped up spending after four years of ‘prudence’. The current surplus turned into a steadily rising deficit in money terms but a manageable share (less than 2%) of GDP.

The recession, which started in 2008, however, not only undermined Chancellor Darling’s plans but also highlighted the risks of his predecessor’s spending from 2001 to 2007. As a share of GDP, the current deficit rose to 9.3%, almost 50% higher than the previous peak in the 1990s (6.3% in 1993-94), with net borrowing (at £175 billion) more than three times higher than the pre-1997 peak.

The public sector net cash requirement (previously called the public sector borrowing requirement) is the amount the Government needs to borrow to fund any current account deficit plus its expenditure on public sector investment plus any financial transactions it carries out.

The turnaround in the current balance was instrumental in reducing this borrowing in relation to GDP. Indeed in the period from 1998 to 2001 debt was repaid in each year.

Net repayment of debt means, of course, that, as long as interest rate levels remain steady, future debt repayments are reduced. The receipts from the Government’s sale of third generation mobile phone licences in 2000, moreover, were used to repay outstanding debt and this also served to reduce debt repayments.

Reduced debt interest repayments left Government with a range of choices. The reduction could have been used to repay further debt, to boost other expenditure such as health or education or to allow taxes to be reduced.

When the Labour Government started its second term of office in 2001, it chose to boost expenditure, especially on the health services and on education, but also on transport, reversing the trend of earlier years.

But, given that the economy grew below trend in 2001, 2002, 2003 and 2005, this raised worries about weakening revenues causing a sharp deterioration in public finances.

In particular, it led many commentators to argue that the Chancellor’s fiscal rules would be broken in the current cycle.

In the final analysis, however, and after a number of changes to the Golden Rule in terms of the measurement of surpluses and deficits, and of the starting and ending dates for the cycle, the Golden Rule passed its first test.

The sustainable investment rule under its current definition of what is included in public sector debt also passed muster.

Net debt as a proportion of gross domestic product was calculated by the Treasury at 36.5% of GDP in 2007-08, immediately before the recession.

Still within the 40%, it was however, creeping up from the low of 29.7% in 2001-02. The recession has made a nonsense of both fiscal rules and left public finances in a parlous condition.

The single biggest casualty of the recession is the state of government finances. Growth will recover, unemployment will stop falling and confidence will slowly return but, even on Chancellor Darling’s own optimistic forecasts, the current budget deficit will still exceed 5% of GDP in 2013, net borrowing will be north of £100 billion and public sector net debt will be equivalent to three quarters of the value of the economy.

Clearly, the scope for any government to improve public sector services or cut taxes will be severely constrained into the medium term.

The 2009 Budget revealed that the combination of falling tax revenues (down from £516 billion in 2007-08 to £465 billion in 2009-10) and rising spending would push public sector net borrowing close to 10% of GDP and net debt to upwards of 50% of GDP for the first time in over 30 years. And there is no real improvement in the five-year forecast period of the Budget.

Although Mr Darling cannot really be held accountable for the dreadful state of the public finances in 2009, he could have been braver in signposting an exit strategy for getting the numbers back into reasonable shape.

Part of the reason for this was political – an unwillingness to make unpleasant decisions 12 months before an election. But the message is very simple. Some combination of sizable tax increases or substantial spending cuts will be the only route to re-establishing some stability in the government’s financial position. And the situation will worsen as interest rates return to more normal levels, adding to the costs of servicing the debt.