Rachel Reeves's Big Opportunity

A guest post by John Crompton on how the chancellor can turn the revelation of a £22 billion black hole in Britain's public finances to her and the country's advantage

Photo by NASA Hubble Space Telescope on Unsplash

I am delighted to publish this guest post by John Crompton on how to fix Britain’s public finances following Rachel Reeves’s revelation of a £22 billion black hole in the accounts. John is a former Treasury official and investment banker as well as a co-author of Public Net Worth, published earlier this year. The inadequacy of Britain’s fiscal rules and the extent to which they have driven poor policy decisions over many years has been a recurring theme in the Wealth of Nations. Given the fiscal challenges faced by all Western democracies at a time of historically high debt levels and weak growth, John’s recommendations apply well beyond Britain.

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Britain’s Public Finances: Integrity, Inadequacy… and Opportunity?

John Crompton

The current spat over Britain’s fiscal position – a “£22 billion hole in public finances” - between new Chancellor of the Exchequer Rachel Reeves and her predecessor Jeremy Hunt highlights two issues with UK public finances.

First, there is a concern about the integrity of the information on which government fiscal decision-making is based. This is very serious, especially if a false or misleading picture of the fiscal position has been incorporated in the various party manifestos that informed the recent General Election. The intervention by Richard Hughes, Chair of the Office of Budget Responsibility, makes it clear that he believes that the information provided by the Treasury to his independent unit which assesses the country’s fiscal position might have been incorrect. If this proves to be the case, then changes will need to be made to address a real threat to the democratic process.

But second, Rachel Reeves’ response to the £22 billion shortfall demonstrates the inadequacies of the fiscal rules within which she has chosen to operate. These focus solely on debt levels and debt issuance. As a result, no assessment is made of the use to which expenditure is applied - for example, whether it is used to fund current spending or invest in infrastructure - or of non-debt liabilities incurred as a result of spending decisions. This can lead to perverse outcomes.

So cutting expenditure on significant public investments such as road programmes or hospital construction, as Reeves has announced, might help her keep within debt-to-GDP ratio targets, but it will also deprive the country of projects which presumably represent good value for money (or they would not have been adopted in the first place), and which would have delivered benefits over many years to come.

Similarly, the £9.4 billion annual cost of meeting above-inflation public sector pay recommendations (part of the “£22 billion hole”) that she has announced will bring with it additional costs in terms of higher future pension commitments. These are probably of the order of 40% of the aggregate pay increase, or some £3.5-4 billion per year. These are non-funded commitments, so they don’t affect performance versus fiscal targets. But they are just as much debt obligations as Gilts, since they will need to be met by taxpayers when they come due.

If the fiscal rules treatment of capital expenditure is foolish, the treatment of pension liabilities, similar in magnitude to Gilts, is downright misleading.

The opportunity that Rachel Reeves has missed - so far – is to adopt fiscal rules based upon an accounting-based measure of net worth that reflects both the asset and liability sides of the public balance sheet, rather than the net debt framework she has inherited. 

Such rules need be no less stringent than our current rules. But they would allow the Chancellor to account for capital expenditure not as it occurs, but as the capital is consumed through depreciation, thereby giving a much more accurate picture of the true state of the national balance sheet and the country’s long-term wealth.

To illustrate this point, imagine that the £9.4 billion that Reeves is spending on public sector pay rises was spent on capital investment, as had originally been intended.

Under current rules, it makes no difference how the money is spent: all that matters is the impact on in-year borrowing and total debt. But under a net worth-based rule, the Chancellor would need to consider both how the money was being used, and what other effects it would have on long-term public finances.

So suppose that the £9.4 billion was invested in assets with a 20 year life (roads, hospital buildings and equipment, etc). Under a net worth-based rule, only that part of the asset which was used in a given year - in accounting terms, its depreciation - would need to be taken into account in any given year. In other words, net worth would be reduced by £470 million per year in this example.

However, in the case of the pay rises, net worth would decline by the full £9.4 billion not just this year, but every year since the pay rises are a recurring obligation. What’s more, under a net worth rule, the impact on future pension liabilities would also need to be deducted. Assuming that these are accrued at a net 40% of the pay increases, this would imply an additional £3.8 billion of costs not recognised under the current rules. So the total impact would be to reduce net worth by £13.2 billion per year.

That is a pretty big difference, and suggests that current rules are severely distorting financial decision-making. It is not surprising that our public infrastructure is crumbling when decisions are made like this. And in case anyone thinks that this simply creates a licence for unconstrained capital expenditure funded by borrowing, consider this: in the absence of windfall gains, net worth can only be held constant if the use of resources (i.e., current spending plus asset depreciation) is matched by revenue. That provides an important in-built check on short-term extravagance. 

More broadly, using net worth-based fiscal rules would open up opportunities for radical improvements in government finances. 

A focus on net worth would force government - at all levels - to account for public assets, and to manage them for value. For example, based on our estimates and drawing on numerous international comparisons, government-owned property assets are likely to be worth around 100% of GDP. Britain’s Whole of Government Accounts, a consolidated set of financial accounts for the UK public sector published annually, suggest a figure closer to 20%. But these accounts value property on the basis of historic cost or current use. This fails to capture their true market value, or to allow challenge as to whether assets are being used to their best advantage.

The IMF’s broad-brush estimate is that the annual lost return on under-managed government assets is 1.5% of their value. This suggests that there is scope for improving public finances in excess of 1% of GDP though this measure alone. In contrast, Rachel Reeves’ plan to help fill the £22 billion “hole” through sales of unneeded property suggests a fire-sale, rather than a considered strategy to maximise the value of these assets in the public interest.

Even more dramatic are the opportunities opened up by applying the net worth framework to public sector pensions. For a start, these would be treated as the debt obligations that they really are. If these pension obligations had been recognised as such when they occurred, and been funded by taxpayer contributions to an investment fund, as would be required in the private sector, then Britain’s public finances would be enormously better off now. Even if the government were to fund these pensions today, by borrowing and investing, it could expect a near-certain long-run return on investments well in excess of the cost of servicing debt. Over a generation, the obligations could be fully funded, and public finances improved by around 3% of GDP.

Combining the asset and liability management opportunities suggests that total improvements in public finances of over 4% could be realised over time - very close to the 4 - 5% that the OBR reckons is needed every year, for the next 50 years, to tackle the long term demographic challenges to public finances. 

So learning lessons about the integrity of government financial forecasts is important. But putting in place the right fiscal framework, based on accounting net worth, offers the prospect of safer, stronger public finances, to the benefit of all.

Rachel Reeves should not let the opportunity slip by.

JOHN CROMPTON is a former investment banker and three-time HM Treasury official and advisor, and the co-author, with Ian Ball, Willem Butter, Dag Detter and Jacob Soll, of Public Net Worth—Accounting, Government and Democracy (Palgrave MacMillan 2024).