Removing policy banks from the fiscal rules will lead to more growth

Rachel Reeves is expected to announce more public investment in the 2024 Budget. Daisy Jameson argues that this investment can be funded by changing the fiscal rules by excluding the policy banks from the UK’s debt rule. Doing so could result in an additional £3.2 billion in economic output. 

It is understood that the Chancellor will announce additional public investment in the upcoming Budget. This investment is welcome, particularly if used to address the gap in investment required for the UK in its transition to a clean economy.

However, there is debate as to the best way of generating the fiscal space needed to finance this investment. The Chancellor has options: she can reform the current fiscal rules to allow for additional borrowing, she can reallocate existing spending, or she can raise taxes. Of course, these options are not mutually exclusive. The investment gap could be addressed using a combination of all three.

CETEx has previously discussed some options for reforming the fiscal rules, including:

• Selecting an alternative measure of fiscal sustainability instead of Public Sector Net Debt (e.g. Public Sector Net Worth or Public Sector Net Financial Liabilities).
• Excluding the UK’s policy banks (government-owned financial institutions like the National Wealth Fund, British Business Bank, UK Export Finance, that invest through loans, guarantees and equity, in commercial markets to help deliver government policy) from the UK’s debt rule.
• Removing the Bank of England’s Asset Purchase Facility (the mechanism established by the Bank of England to implement its quantitative easing programme that has cost the Treasury £61 billion since October 2022) losses from the debt rule.

Here I will discuss the second of these options and estimate the benefits of removing the UK’s policy banks from the UK’s debt rule. We find that every £1 billion a year of sustained additional investment unlocked by removing the UK policy banks from the Government balance sheets could generate as much as £3.2 billion in potential economic output (strongly correlated with GDP), yielding as much as £1.9 billion a year in additional tax revenue.

What are policy banks and how to free them

The UK’s policy banks are currently classed as central government entities and rely on funding allocations at each spending review, competing with other spending pressures. However, unlike other central government investments, they make investments by financing private sector assets through loans or equity stakes. In return, they receive a financial asset (or a fee from providing a guarantee). This financial asset is not reflected in Public Sector Net Debt (PSND), so the benefit of these investments does not count against the UK’s fiscal rules.

Policy banks are therefore constrained in the volume of capital they can invest in a given budget period due to these fiscal rules. Also, their funding allocation is uncertain beyond this cycle, undermining their ability to provide reassurance to the market.

We recommend that, like their international counterparts, the UK’s policy banks are excluded from the UK’s fiscal rules and are allowed to grow their balance sheet without this artificial constraint. Unlike some reforms to the fiscal rules, this would allow for the policy banks to borrow from the market, change the way they invest and become more activist in the market (although others, including measuring PSNFL and PSNW could have a similar effect).

Impact of removing policy banks from the fiscal rules on investment and potential output

CETEx have used the Office of Budget Responsibility’s estimates of the impact of public investment on potential output to understand how this additional investment may drive economic growth. The economy’s potential output in this context is the value of goods and services that an economy can generate when its productive resources are being utilised at their maximum sustainable rates. It is the key determiner of GDP growth. We have previously estimated a £15 billion increase in investment over five-years if the policy banks were removed from the fiscal rules (relying on existing balance sheet size and modest growth if unconstrained). Assuming this is equivalent to an additional £3 billion a year, and that this increase in investment was permanent over the coming 10-years, this would give an increase in potential output as seen in scenario 1 in Figure 1.

Figure 1 shows how an increase in public sector net investment above the baseline can increase potential output, and ultimately GDP growth in the medium to long-term. The long-run impact on potential output (in 50 years) is equivalent to £7.2 billion in today’s terms.

The OBR suggests that investing primarily on economic infrastructure (e.g. energy or transport infrastructure), rather than a mixture of economic and public infrastructure (e.g. schools) could result in a 33 per cent larger impact on potential output. This would increase our above estimates to those seen in scenario 2, with the long-run impact reaching £9.6 billion.

If the banks are successful in generating favourable market conditions that attract additional private finance, as the Chancellor has committed to, the impact on potential output could be magnitudes larger than these estimates. This additional investment would also increase tax revenues. Assuming, as the OBR have, a fiscal rate of return via higher tax revenues of 1.9, an additional £3 billion of annual investment could raise £5.7 billion over 10 years.

There is no doubt that the UK needs more public investment. We recommend taking an approach to reforming the fiscal rules that both allows for this additional investment and encourages the UK policy banks to grow their operations.

This article was originally published on the LSE British Politics and Policy Blog