Page last updated at 02:52 GMT, Tuesday, 30 September 2008 03:52 UK

Osborne reforms raise questions

By Robert Chote
Director, Institute for Fiscal Studies

George Osborne
George Osborne plans to consult on the precise details of his proposals

Gordon Brown's decision to make the Bank of England independent in 1997 is widely hailed as having taken the politics out of interest rate decisions.

Mr Brown's famous fiscal rules were supposed to do the same for the management of the public finances, but they are now regarded by most informed observers with scepticism at best and cynicism at worst.

The proposals to reform the fiscal policy framework announced by George Osborne would be a welcome improvement, although there is much work still to be done on the details.

The two key elements echo suggestions we have made in successive Green Budgets: first, to adopt forward-looking targets that do not depend on the Treasury deciding exactly when an economic cycle began and is going to end; second, to make official forecasts of the public finances more independent, allaying the suspicion that they reflect politically inspired wishful thinking.

The two targets that Mr Brown set himself in 1997 were the "sustainable investment rule" (to keep public sector net debt below 40% of national income) and the "golden rule" (to borrow only to pay for capital investment on average over the ups and downs of an economic cycle).

Neither is optimal, but both are reasonable as rules of thumb.

Over-optimistic forecasts

Early in Mr Brown's Chancellorship, it looked as though both would be met with tens of billions of pounds to spare.

The problems began after the 2001 general election, when a falling stock market helped cut tax revenues by 2.4% of national income (35bn in today's money) in just two years, pushing up borrowing.

The Chancellor began a run of seven successive over-optimistic Budget forecasts: first underestimating how big the government's deficit would become and then overestimating how quickly it would shrink.

From 2002 onwards we argued in each of our annual Green Budgets that Mr Brown was being over-optimistic and that he would have to increase taxes or cut spending to bring about the improvement in the public finances he had been looking for in the previous Pre-Budget Report.

But in a sustained display of conviction forecasting, he repeatedly dismissed any such suggestion - until immediately after the 2005 general election, when he raised taxes and signalled cuts in spending as a share of national income.

By that time he was also on course to break the golden rule - until he pushed back the estimated start date of the cycle by two years, which conveniently made the average budget balance look healthier.

Earlier action

Delaying the fiscal tightening and redating the cycle both undermined people's confidence that the rules were a sufficient constraint on tax and spending decisions.

The years of slippage also saw the Treasury's forecast for the peak in public sector net debt rise from 31% of national income in Budget 2002 to 39.8% in Budget 2008, leaving virtually no room for manoeuvre in the event of even a modest economic slowdown, let alone one as big as that on which we are now apparently embarked.

Would Mr Osborne's reforms have ensured a happier ending? Well, if politics did intrude on the Chancellor's predictions and his decisions regarding the cycle, then placing responsibility for fiscal forecasting in the hands of an independent Office of Budget Responsibility - with access to the same privileged information on spending and revenues that the Treasury currently enjoys - might have prompted earlier action to strengthen the public finances.

And if the Chancellor's forecasts and decisions were the best possible predictions given the available information - and let us not forget that forecasting the public finances is never easy - then at least no one would have suspected political interference, helping to maintain trust in the framework.

Broad approach

Mr Osborne now plans to consult on the precise details of the scheme. There are many issues he will wish to ponder, among them:

First, does his proposed target of having debt falling at the end of a still-to-be-determined forecasting horizon give a clear enough long-term goal for policy? Should we be setting out to emulate the one-third of OECD countries that now hold net financial assets rather than net debt?

Second, who exactly should be responsible for the new Office's fiscal forecasts and for recommending how much the Chancellor should tighten or loosen the Budget?

A large dissent-tolerant monetary policy committee may be the right body to set interest rates, but a smaller group reaching a consensus would seem to be preferable here. To bolster their independence, its members should have terms longer than a parliament.

Third, what economic forecasts should underpin the office's fiscal forecasts? The credibility of the office should not rest on its skills (or luck) as a macroeconomic forecaster.

Using forecasts from the Bank of England would help ensure coherence between monetary and fiscal policy, but the Bank may be reluctant to give a view on the sustainable growth rate of the economy and to be implicated in the office's advice.

These and other practical questions will need answering, but the broad approach is a good one.

Whether it is the Conservatives who end up doing the job or not, the fiscal framework is certainly in need of repair.

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