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Public Policy PerspectivesTime to rewrite the UK’s fiscal rulebook

November 2016This document is for investment professionals only and should not be distributed to or relied upon by retail clients.

102 Public Policy Perspectives


Introduction

Executive summary

EU exit raises short and long-term challengesThe UK economy is likely to slow over the coming quarters following the vote to leave the European Union (EU). Exit will also weigh on long-term growth, especially under those scenarios in which the UK leaves the Single Market. This would exacerbate the structural deterioration in growth seen over the past decade.

Co-ordinated fiscal and monetary stimulus needed to address near-term economic risksToo much weight has been put on monetary policy since the financial crisis, with fiscal policy working against the recovery. Fiscal stimulus will have a more powerful effect on growth in the current environment in which Bank of England measures are reaching their limits and the transmission of monetary policy to the economy is still impaired. Indeed, by raising growth and inflation expectations, a well-designed fiscal package would crowd-in rather than crowd-out private sector activity.

A fiscal package should support long-term growthPublic investment has been weak over recent years and the UK scores poorly in international infrastructure rankings. Targeted investment would help boost productivity and potential growth. The UK also suffers from other structural shortcomings, including inadequate housing supply, skills and human capital shortages, and inefficiencies in the tax system. These issues cannot all be solved in one fell swoop, but the government should prioritise reform in these areas during the current parliament.

Rewriting the rulesA new fiscal framework would provide scope for a large and sustained fiscal loosening, while also accommodating investment-related borrowing through the economic cycle. We advocate an immediate fiscal stimulus of 1.25% of GDP alongside current monetary accommodation. Thereafter, the Chancellor should be flexible. If the economy performs worse-than-expected, policy should be loosened. If growth improves more-than-expected, then a gradual consolidation can be considered.

Invest in infrastructure to get the most ‘bang-for-your-pound’The package should be directed at those areas which generate the greatest short-term impetus, while also providing longer-term benefits. Infrastructure investment ticks both of these boxes. We would advocate a permanent increase in infrastructure investment of 0.75% of GDP per annum, with spending tilted toward smaller-scale investment in local transport projects.

Welfare and departmental spending should also be prioritiesIncreased welfare transfers generate stronger multipliers than direct and indirect tax cuts due to welfare recipients’ higher propensity to consume. Increased funding should also be earmarked for the Sure Start early intervention education programme and Post 16 Skills Plan around vocational training to help address the UK’s human capital shortfalls.

Removing distortions from the tax and housing systemsEasy wins for tax reform include an extension and simplification of capital allowances and a more consistent tax system for the financial sector. Longer-term priorities include a tax allowance for corporate equity to remove the bias toward debt financing, and shifting taxation away from property values and transactions, towards land. The government should redouble its efforts to increase housing supply through further planning reform and increased incentives for building.

James McCannUK/Europe Economist

Stephanie KellyPolitical Economist

‘Time to rewrite the UK’s fiscal rulebook’ is the first in a series of Public Policy Perspectives, a new research publication that aims to broaden the debate on policy issues across a range of economies and make neutral, evidence-based recommendations.


Rethinking fiscal policy

The UK’s vote to exit the EU has raised concerns over the country’s short and long-term economic outlook. Indeed, this adds to evidence that potential growth in the UK has been falling over a number of years (see Chart 1). Against this backdrop, fiscal policy is firmly in the spotlight, with the new Chancellor’s Autumn Statement fast approaching. The government has attempted to consistently tighten fiscal policy since 2010 and until the EU referendum result had been planning significant further tightening through the rest of the parliament. This paper will argue that the government should abandon its austerity plans and instead announce a fiscal stimulus. There is strong evidence that easier fiscal policy will provide a powerful boost to activity in the current environment in which monetary policy is overburdened, particularly if directed towards those policies which generate the greatest growth multipliers. Looser policy would also generate room to support the longer-term growth potential of the economy, which has deteriorated significantly over the past decade. Action should focus on addressing inadequacies in sections of domestic infrastructure, skills shortages, tax inefficiencies and housing undersupply.

The paper is organised as follows; first, we examine the theoretical and empirical research on fiscal policy and how this has evolved since the financial crisis. Second, we use this evidence to make recommendations on how the government should set fiscal policy. This includes a rewriting of the current fiscal rules and the announcement of a carefully calibrated fiscal stimulus. The third section of the paper looks at how a stimulus should be designed to maximise the positive impacts on growth.

Here, we examine the multiplier effect of different policies and use the ‘Input-Output’ tables (I-O) to map how these feed through the economy. Finally, we look at some of the structural shortcomings in the UK economy, from weakness in sections of infrastructure to skills shortages. We make some policy recommendations to address these key issues.

Getting the mix rightAcross the developed economies there has been an overwhelming reliance on monetary policy to manage demand since the financial crisis. Whereas central banks have maintained a consistently accommodative policy stance through the deployment of both conventional and unconventional policy tools, fiscal policy has been conducted more haphazardly. It was loosened in the immediate wake of the downturn, before being tightened in many countries, including the UK, after 2010.

This unbalanced policy response has been problematic because there have been severe limits on what monetary policy could achieve in the post-crisis environment. While central banks are not out of ammunition, they quickly reached the effective lower bound with regards to conventional interest rate policy. The effectiveness of their unconventional measures has been constrained by persistently weak demand, ongoing private balance sheet repair and a tighter financial regulatory environment, which have combined to leave many economies in, or close to, liquidity traps.

Chart 1 – UK potential growth

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0.5%

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1.5%

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2.5%

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3.5%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: OECD


In these circumstances fiscal policy becomes more powerful (see Table 1). Multipliers rise during downturns as there is less risk that public spending crowds out private activity given the rise in spare capacity. This effect becomes even more powerful when the economy is mired in a liquidity trap; not only does the boost to aggregate growth from fiscal stimulus increase but it may even crowd in private activity. The theory behind this is examined in the box on page 4.

It is also important to note that in a liquidity trap, perceived budget constraints on fiscal policy become less relevant, even at the high prevailing levels of public debt. With limited or no crowding out, any increase in interest rates is likely to be modest and expansion may actually help support fiscal sustainability by boosting growth and inflation in the short term and, if well directed, the long-term too.

The experience of austerity in the UK over recent years shows the risks of underestimating fiscal multipliers. The effects of austerity were calibrated by the Office for Budget Responsibility and Treasury based on IMF multipliers derived during more normal economic times.

In the post crisis environment in which spare capacity has been higher, monetary policy ammunition limited and the transmission of this impaired, the actual effects of fiscal policy changes were larger. This helps explain why OBR forecasts have been too optimistic on both growth and the public finances (see Chart 2). Indeed, the economy showed a material improvement when austerity essentially stalled further into the last parliament.

The government should heed these lessons when reacting to the current slowdown. An optimal policy response to the UK referendum result would incorporate an easier fiscal policy, alongside an already loose monetary policy. This would help deliver a quicker and stronger recovery. It would also take some of the pressure off the central bank and help to soften any side effects and distortions from current monetary policy measures. The government should not repeat the policy mistake of recent years and leave too much of the leg work to the central bank.

Addressing the UK’s structural problemsAnother criticism of fiscal policy since the financial crisis is that it has not addressed some of the UK’s key structural or supply-side shortcomings. There is clear evidence that UK potential growth has been slowing over a number of years.

The OECD estimates that the UK’s potential growth rate is just 1.8% at present, well below the 2.6% average seen in the 20 years before the crisis. All of this deterioration reflects unusually poor labour productivity performance.

Fiscal policy can play an important role in supporting productivity through structural reform and infrastructure investment. Unhelpfully, public investment was one of the first parts of government spending to be cut in 2010 (continues on page 5).

Chart 2 – OBR forecasts*

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March-2011 March-2012 March-2013 March-2014 March-2015

*Cyclically adjusted budget balance (% of GDP)March-2016 November-2010

2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20

Source: OBR

Recommendation 1Loosen fiscal policy to support growth and take the strain off monetary policy.

Table1 - Fiscal multipliers over the business cycleSpending

Expansion Linear Recession

Auerbach et al. (2012a) (USA) 0 0.4 1.7

Auerbach et al. (2012b) (OECD) -0.2 0.2 0.5

Auerbach et al. (2014) (Jap) 1 1.2 2.4

Batini et al. (2012)m(All countries) 0.82 0.93 2.08

Batini et al. (2012)m( G6 Average) 0.72 0.79 1.22

Canzoneri et al. 2012, DSGE (USA) 0.89 1.3 2.25

Hernandez de Cos et al. (2013) (Esp) 0.6 0.65 1.3

Owyang et al. (2013), (USA) 0.7 N/A 0.8

Owyang et al. (2013), (Canada) 0.4 N/A 1.6

Source: Standard Life Investments


Fiscal policy in the IS-LM framework

The IS-LM model (Investment-Savings, Liquidity-Money) helps determine a level of output and interest rate at which both the goods market (IS curve) and money market (LM curve) are in equilibrium. It is not without its shortcomings, but IS-LM does provide a useful tool for policymakers to help predict how the demand side of the economy might react to different shocks.

Let us break the model down into its two constituent components. First, the IS curve traces the combinations of interest rates and GDP which balance desired saving and investment (the goods market). How does this work in practice? Let us imagine that desired saving and investment are equal, and interest rates fall. This lower interest rate increases desired investment, boosting economic activity and the level of income. This increase in income will be in part saved, helping bring desired saving and investment back to equilibrium at a higher level of GDP and the new interest rate. The LM curve approaches the interest rate question from a different angle – that of the money market. This tracks the trade-off between holding money, which has the advantage of being liquid, or bonds, which pay interest. This liquidity preference defines a set of combinations of interest rates and output which are needed to match the supply and demand for money. Again let us work through an example; an increase in growth will raise the demand for liquid money to fulfil the higher transactions. This will require an increase in interest rates to balance the supply and demand of money.

The IS-LM model unifies these two approaches into a single framework. The point at which the IS and LM curve intersect represents the equilibrium interest rate and level of output at which the goods (IS) and money market (LM) are both in balance. Under normal economics conditions it is assumed that monetary policy shifts the LM curve and fiscal policy shifts the IS curve. For example, a fiscal stimulus leads to a rightward shift in the IS schedule, which brings a new equilibrium with the LM curve at a higher rate of output and interest (to balance the money market). From a policymaker perspective, the increase in activity is positive, but higher interest rates risk crowding out private investment (see Chart 3).

The IS-LM framework becomes particularly useful when thinking about how an economy performs in a liquidity trap. In this environment, the LM curve flattens as rates reach zero with the economy still depressed and in need of accommodation. Going back to our liquidity preference, as interest rates fall to zero there becomes no trade-off between holding cash and bonds. When this happens, and money is being held as a store of value, changes in the money supply (monetary policy) have little effect. In this environment, a structural loosening of fiscal policy shifts the IS curve to the right, by reducing the excess of saving over investment and boosting aggregate output. This IS curve finds a new intersection, with the LM schedule at an unchanged or slightly higher interest rate, reducing the risk that there is a crowding-out in private sector activity (see Chart 4). Indeed, there is even some potential for these policies to crowd-in private investment by raising growth and inflation expectations.

Despite its limitations, the IS-LM framework has successfully helped to explain some of the economic developments we have seen in the wake of the financial crisis – namely weak transmission of monetary policy stimulus, weak growth and low interest rates. Right now it is telling us that fiscal policy is a more powerful tool than usual.

Chart 3 – IS-LM in normal times

Interest Rates

GDP

IS

IS

LM


Chart 4 – IS-LM in a liquidity trapInterest Rates

GDP

0

Full Employment

IS

IS

LM



Despite rhetoric around the National Infrastructure Plan, the latest budget forecasts weak aggregate investment through the current parliament (see Chart 5). Moreover, there is little evidence that policymakers are actively tackling what we consider to be some of the UK’s other structural weaknesses.

These include skills shortages, inefficiencies in the tax system and a chronic undersupply of housing. Addressing these issues has become even more acute in the wake of the referendum. As we noted earlier, a potential exit from the Single Market is likely to weigh on longer-term growth prospects, compounding the deterioration in potential growth since the crisis.

Rewriting the rulebookAny material change in fiscal policy will require changes to existing legislation. Current fiscal plans envisage a tightening in policy equating to 1% of GDP over each of the next three years in order to meet self-imposed fiscal rules. The Charter for Budget Responsibility states that the government must achieve a surplus on public sector net borrowing by 2019-20, with this headline surplus to be maintained permanently during ‘normal’ economic conditions. There are caveats in these rules which allow them to be suspended during economic downturns.

A more fundamental redesign of these rules, rather than suspension, is necessary. In principle, independently monitored fiscal rules can be positive in supporting budgetary discipline, improving longer-term fiscal credibility and creating space for counter-cyclical policies during recessions.

However, the UK’s rules have a number of flaws. They are too rigid, constraining the ability of fiscal policy to be run counter cyclically. Moreover, they do not discriminate between public investment and current consumption. A better designed framework would encompass a greater degree of cyclical flexibility and allow borrowing for public investment through the economic cycle, as long as that investment is directed toward projects with a positive long-run return over the cost of borrowing.

Go big or go home?How big a loosening in fiscal policy is appropriate? We noted earlier that the ideal stimulus should help boost demand in the short term while also raising long-term potential growth. Although the UK economy has thus far remained resilient after the EU referendum, we continue to expect activity to slow over an extended period. A sharp rise in inflation over coming months and quarters is likely to squeeze real incomes, weighing on consumer spending.

Recommendation 3Fiscal rules should be flexible and permit borrowing for investment through the cycle.

Recommendation 2Stimulus should be designed to support long-term growth through targeted reform and infrastructure investment.

Chart 5 – UK public investment

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Public net investment (% of GDP) 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21

Source: Office for Budget Responsibility


Meanwhile, weakness in investment and construction is likely to continue as firms remain uncertain over the UK’s future relationship with the EU. This slowdown would raise unemployment and broader spare capacity in the economy. Fiscal stimulus, alongside current monetary policy action, could help close this output gap more quickly. In terms of headlines, we would advocate a structural loosening in the deficit of 1.25% of GDP over the next fiscal year.

Link policy to performanceThe government should not plan an immediate consolidation of its fiscal programme; indeed, it should be prepared to maintain accommodation over many years. This would prevent the multiplier effects swinging into reverse while the economy is still fragile. It would also provide more firepower for structural measures aimed at boosting long-term activity.

What if our forecasts are wrong? If the initial stimulus proves insufficient to fully offset any slowdown in growth then the Chancellor should be prepared to take more aggressive action in subsequent years. If the economy performs more strongly than expected, the government can simply gradually tighten policy over the parliament to reflect this better performance. This state contingency provides a better calibration for

short-term fiscal policy than sticking slavishly to fiscal rules that have been poorly designed (see Chart 6). The size and forcefulness of the initial loosening reflects the downside risks to the UK during the coming adjustment.

Moreover, there looks to be limited risk of overheating the economy with the Bank of England struggling to consistently hit its inflation target even before the EU referendum vote. Indeed, while inflation is likely to shoot higher in coming quarters on account of the depreciation in sterling, the underlying price pressures in the economy are likely to remain muted. Finally, the stimulus should be carefully designed to boost longer-term growth potential, supporting activity and the public finances over this horizon.

Getting the most bang-for-your-poundHow should the government direct any fiscal expansion? In principle, the options are almost limitless - it can spend more on welfare and other transfers, raise departmental budgets, increase public investment or cut tax rates. When devising the composition of a fiscal package, it is important to take into account the relative multiplier of different policies. While there is a good deal of debate about the absolute size of multipliers for different fiscal measures, there is perhaps more consensus on the relative boost to activity generated by different types of policies.

Chart 6 – UK fiscal policy outlook

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Shallow economic shock

2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21

Slowdown in line with expectations Deeper economic downturn March 2016 Budget plan

Source: Office for Budget Responsibility, Standard Life Investments calculations

Recommendation 4A fiscal stimulus of 1.25% of GDP would help cushion the short-term impact of EU exit and provide funding for long-term growth boosting policies.

Recommendation 5Calibrate fiscal policy over the rest of the parliament on the performance of the economy.


For instance, the OBR’s assessment of UK multipliers ranks income tax measures as having the least effect because households smooth these effects through changes in savings behaviour and tax cuts often benefit households with a lower propensity to consume. The effect of VAT cuts is seen as marginally higher, but still low. The multiplier on welfare spending is seen to be around twice as large, mainly because the propensity to consume is typically higher among recipients. Current departmental spending multipliers are a similar size, while investment or capital spending is by some distance seen as generating the largest effect on activity.

These multipliers provide useful, high-level insights into the growth effects of different fiscal measures. However, they are very broad groupings. We can use the I-O tables compiled by the Office for National Statistics to estimate the effect of more detailed policy choices. The I-O tables provide a detailed portrait of an economy, allowing us to track how an increase in demand for one product spurs demand across other sectors for intermediate inputs. These relationships allow us to calculate output and employment-cost multipliers. We can also measure how much of the increase in demand for intermediate products is imported rather than produced at home. These multipliers are fundamentally different to the macroeconomic multipliers described earlier, which are based on behavioural assumptions related to how agents adjust their supply, consumption and saving decisions based on changes in

incomes. However, they provide a useful lens for illustrating the impact of an increase in government demand.

As a first step, we can cross check the I-O findings with the results of the broader multiplier analysis. Let us take investment spending as an example. The headline multiplier of an increase in construction according to the I-O tables is high at 1.82. The increase in employment costs is also high at 2.01, implying a significant boost to household incomes. We can track the increase in final demand through the economy, with 64 other sectors providing some input to the construction process. These range from cement manufacturing and architectural services, to rental and leasing services. We can use this map of inputs to estimate how import intensive an increase in construction will prove (see Chart 7). Some inputs are heavily imported, including glass products, of which around one-third are bought from abroad. However, when we weight the import intensity relative to the inputs used in construction, then aggregate imports account for just 12.5% of the total inputs outside of this sector. This would support the findings of the higher-level analysis on multipliers; that investment or construction spending generates strong multiplier effects which are not unduly diminished through import leakage.

We can also use these techniques to analyse the changes in transfers to households, through lower taxes or increased benefits (see Chart 8).

Chart 7 – Import intensity of construction

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Wholesale trade services

Wholesale and retail trade

Installation

Architectural and engineering services

Manufacture of cement, lime, plaster

Rental and leasing services

Financial services, ex. insurance

Fabricated metal products

Wood products

Rubber and plastic products

Source: ONS and Standard Life Investments calculations

Chart 8 – Import intensity of household spending

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So� drinks

Meat products

Dairy products

Furniture

Textiles

Alcoholic beverages

Motor vehicles

Electrical equipment

Tobacco products

Computer, electronic and optical

Wearing apparel

Leather and related products

Source: ONS and Standard Life Investments calculations


The primary aim from a stimulus perspective is to boost household consumption, the largest share of which falls on owner-occupier housing. Unsurprisingly, this has one of the lower multipliers (again we should reiterate that these I-O multipliers do not account for shifts in savings behaviour based on changes in government policy). Similarly, spending in the retail sector and in restaurants (the second and third largest share of consumption) has more modest feed through to other sectors. Worse, a number of consumer goods have high import intensity. For example, when dining out at restaurants, around 50% of any alcohol consumed is imported (20% of soft drinks). For computer, electronic and optical products, the share imported is even higher at two-thirds.

When added to the empirical literature on broader multipliers, the verdict on transfer changes is that these tend to have a lower impact on aggregate activity.

The I-O tables also help us estimate the boost from greater departmental spending. To construct multiplier estimates, we use the departmental procurement survey to estimate how each department spends its money.

These data are not perfect, with the survey not aligning with the standard industrial classification used in the I-O tables. However, they can provide an indication of the boost gained from an individual department’s

spending (see Chart 9). It might not be a surprise to see the Department for Transport ranking highest in terms of departmental multipliers given its spending on construction. However, there is a pronounced feedthrough from some other types of departmental spending. Some of the main beneficiaries include Information and Communication Technology, Professional Services, Consultancy and Facilities – all of which have low import content.

Of course, this analysis takes a narrow view of the multiplier effects of different types of departmental spending and does not take into account the quality of the provision of public services.

These findings imply that public infrastructure investment should form the cornerstone of any stimulus. This spending generates the largest growth impetus and we will discuss the longer-term benefits below. We would advocate an increase in expenditure of £15 billion (bn) over the next fiscal year – representing 0.75% percentage points of the 1.25% loosening that we have outlined. Moreover, this higher spending should be maintained over a number of years. This will lead to difficult policy decisions if and when the government looks to eventually tighten policy. However, the long-term payoffs from this spending mean that it should be prioritised over other budget items.

Chart 9 – Departmental spending multipliers

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Ministry of Justice Home O�ce

Department for Work and Pensions Department of Health

Ministry of Defence HM Revenue and Customs

Department for Children, Schools and FamiliesDepartment for International Development

English Local Authorities Department for Business, Innovation and Skills

Communities and Local Government Department for Environment, Food and Rural

Foreign & Commonwealth O�ce Department for Culture, Media and Sport

Department for Transport

Source: ONS, Office of Government Commerce, Standard Life Investments calculations


Infrastructure investment should be complemented by other measures. Welfare spending generates a relatively high multiplier and can have progressive benefits. Indeed, the benefit cap should be re-evaluated entirely. It is regressive with regards to ‘at-risk’ children, it is likely to have significant demand and welfare reducing effects, and it is unlikely to incentivise increased labour supply according to research. In total, 244,000 children from poor households are estimated to be affected by the new benefit cap calculations. The uncertain future for the British economy post-EU exit may result in job losses for those who do not usually fall into this category; so, the numbers affected may grow further.

Finally, targeted increases in current departmental spending can also boost short-term growth. These should ideally be directed towards supporting the structural problems highlighted in housing, education/training and taxation where short-term responses are possible (more complicated reforms should be tackled over the course of the parliament).

Thinking longer termThe degree of short-term stimulus delivered through different policies is just one of the criteria that the government should pay attention to. A second important consideration should be addressing the UK’s structural shortcomings and, in particular, the deteriorating long-term growth outlook. Not all of these issues can be fixed in a single Autumn Statement and will require sustained investment or reform over a number of years. Policy continuity will be key.

We flagged the disappointing trend in public net-investment earlier. There is evidence that neglect over a number of years is starting to take its toll. The World Economic Forum rankings show that the quality of UK infrastructure has fallen from 19th place to 27th globally since 2006 (see Chart 10). In particular, the UK scores poorly for road quality, down 16 places to 30th since 2006, and airport quality, down 16 places to 28th. Rail infrastructure quality has improved according to these rankings, but at 16th place is still not particularly high compared to peers.

The returns from well-targeted infrastructure investment can be high. Note the ‘well-targeted’ caveat here. There is a large body of empirical literature examining the relative benefits of different types of infrastructure spending (see Chart 11). Indeed, the Eddington review has looked at transport infrastructure in detail. The consensus is that small scale, well-directed spending on local road and rail projects tends to have larger benefits than grand marquee projects.

Chart 10 – WEF infrastructure rankings

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Quality of air transport

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supply

Available airline seat km/week

Infrastructure score

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Fixed telephone

lines/100 pop.

Quality of railroad

infrastructure*

Current Ranking Ranking Change (2006-2015)*Railroad infrastructure compares 2009 to 2015 due to data availability.

Source: World Economic Forum

Chart 11 – Benefit-to-cost

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High Speed Line London-Manchester Rail

Crossrail Hybrid Scheme

A228 Main Road to Local Road

Thameslink Upgrade

A66 Tees Valley Local Road

A228 Leybourne Bypass

A1073 Spalding Improvement

A167 Chilton Bypass

Heysham to M6 Link Local Road

A13/A138 Sadler’s Farm Junction

Source: Eddington review

Recommendation 6Stimulus should focus on public investment, departmental spending and welfare spending to generate the best short-term return. Direct or indirect tax cuts would represent a weaker stimulus.


Moreover, there are practical elements to consider, with these projects likely to be quicker to progress while they tie up a smaller portion of the budget.

The government is aware of infrastructure shortcomings. Its National Infrastructure Delivery Plan promises to deliver £100bn in investment by 2021. However, there are some issues with this. First, it tends to focus on large projects, contrary to the findings of research that small, well-directed investment yields the best returns. Indeed, none of the nine major transport schemes devised in 2011 have been completed and five have not yet started. We would advocate a diversion of this funding towards local schemes.

Second, the plan relies very heavily on private sector investment in infrastructure. Private firms may well be more reluctant after the referendum result given the lack of clarity over trade and regulatory conditions.

The government should either increase the incentives on offer or preferably use its own balance sheet as we have advocated. Finally, the government should make the National Infrastructure Commission fully independent, rather than an executive agency of the Treasury. An independent body would be in a stronger position to identify and implement the best investments, free from political influence.

Mind the skills gapThe UK needs to improve its human capital. The Organisation for Economic Co-operation and Development notes that PISA (Programme for International Student Assessment) test results of UK students in science and reading proficiency are only around the international average, with a tendency to show a high variation across students (see Chart 12). This comes in spite of higher GDP-per-capita and education spending. Moreover, employers report significant skill shortages in sectors requiring technical skills, such as skilled trades, where 43% of hard-to-fill vacancies were due to skill shortages.

Early childhood intervention (ECI) is critical for cognitive development, with international research showing spending on this stage of education provides the highest returns. The government’s devolution of ECI programmes to local councils is good practice. However, funding for Sure Start children’s centres has been falling significantly. Between 2010-11 and 2015-16, spending by local authorities on early intervention services for children, young people and families fell by 31% in real terms.

Chart 12 – UK PISA rankings

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United Kingdom

KoreaJapan

Finland

Estonia

CanadaPoland

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ndIre

land

Germany

Australia

Belgium

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United Kingdom

Austria

Czech RepublicFra

nce

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OECD averageNorway

United States

LuxembourgSpain Ita

ly

Portugal

Hungary

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Sweden

Russian

Israel

Slovak RepGreece

OECD average

Source: OECD

Recommendation 7Increased infrastructure spending should be targeted at the UK’s deficiencies in road and rail transport. Spending should address local, small-scale infrastructure improvements rather than grand projects. The government should grant full independence to the National Infrastructure Commission to avoid spending being influenced by party politics or the electoral cycle.


This includes Sure Start children’s centre budgets being reduced by almost half (48%) in the last five years. Increased spending in this area is likely to deliver significant future benefits.

In terms of vocational skills, the Post-16 Skills Plan devised following the Sainsbury Review is a step in the right direction. This aims to improve technical and vocational training, providing a clear simplification of the previous system. This has become even more critical considering the severity of the skills shortage in key industries (e.g. construction, where 35% of hard-to-fill vacancies are due to skills shortages) and uncertainty over future EU labour supply (see Chart 13). To be successful the plan needs to be well funded, particularly through the college system. We would also like to see the government share the burden of apprenticeship schemes with industry.

Taxing timesParts of the tax system are overly complex, disjointed and distortionary and, therefore, ripe for redesign. However, large-scale reform is politically difficult and time consuming. We have identified some areas in which efforts should be concentrated over the current parliament.

First, there are ‘easy wins’ to be had in extending and simplifying capital allowances beyond SMEs to larger firms in order to boost investment incentives. Meanwhile, a more stable and consistent tax system for the financial sector would reduce the uncertainty following numerous changes over recent years. In terms of bigger picture thinking; the establishment of an allowance for corporate equity would resolve the existing unequal tax treatment of debt and equity, reducing distortions. This could also have the effect of lowering the average effective corporate tax rate, as was the case in Belgium (see Chart 14). This could reduce pressure to lower the statutory corporate tax rate, which costs approximately £2bn per ppt reduction.

Finally, business rates should be reformed to tax land rather than property values and transactions, which would reduce distortions due to the fixed nature of land supply. However, small changes could also be powerful within the current framework. For example; more frequent valuations would prevent large changes in charges, while further devolution of this tax to local authorities would incentivise corporate development projects.

Recommendation 8The government should aggressively implement the recommendations of its reviews on early child intervention and vocational skills. Greater funding should be directed to these priorities.

Recommendation 9Inefficiencies in the tax system should be actively addressed. In the first instance, the government should target small changes in capital allowance and set out a stable and consistent tax system for the financial sector. More ambitious goals should include a tax allowance for corporate equity and reform to business rates.

Chart 13 – Skills shortages by sector

0% 5% 10% 15% 20% 25% 30% 35% 40%

Public Administration

Education

Hotels & Restaurants

Wholesale & Retail

Financial Services

Health & Social Work

Arts & Other Services

Agriculture

Business Services

Manufacturing

Transport & Communications

Electricity, Gas & Water

Construction

2015 2013

Source: Employer skills survey

Chart 14 – Lowering the debt bias in Belgium

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2012

E�ective marginal tax rate on equity E�ective marginal tax rate on debt Tax wedge Debt-Equity

Source: European Commission


Safe as housesOur analysis suggests that Britain has accumulated a housing shortfall of three million units over the past 15 years as housing completions have failed to keep up with population growth. Too little land is released for development, and planning laws unduly increase the cost of developing land. These problems extend beyond the housing sector and into commercial real estate. Research undertaken by Paul Cheshire at the London School of Economics before the crisis found that implied regulatory tax rates on office real estate were among the highest in the world. Importantly, the problem is not isolated to London; even regional cities like Manchester had prohibitively tight restrictions, especially compared with American cities. Onerous supply restrictions on real estate are an economic problem. They increase congestion, distort the capital stock and make it harder for successful cities and regions to grow.

Existing housing policies place too much focus on demand-side solutions (e.g. Help to Buy) to a supply-side issue, which puts further upward pressure on house prices, exacerbating affordability issues. The recent reforms around the planning system have yet to deliver an improvement in starts or completions sufficient to materially reduce the UK’s housing shortfall (see Chart 15). More aggressive intervention is required over a number of years to deliver a more substantial supply response. Policy action might include land release, devolving stamp duty, well-

targeted investment and green belt land swaps. Local authorities have an important role to play in the process; compensation (via grant or localised tax options) or reclassification of local council borrowing for housing investment can incentivise greater local land release.

Conclusion – time for a resetThe Chancellor should rewrite overly restrictive fiscal rules and announce a targeted loosening in fiscal policy in his Autumn Statement. There are short and long-term reasons to justify this switch. While the initial impact of the EU referendum result has been more muted than feared, there are clear signs that the economy will soften. Fiscal stimulus will help cushion this slowdown, with too much of the burden of recent adjustments having been borne by central banks. A co-ordinated policy stimulus would deliver a stronger recovery. If this package is well designed it could also help support the UK’s longer-term growth potential, through investment in infrastructure and structural reform. With borrowing rates near unprecedented lows, the government should seize this opportunity to boost short and long-term living standards.

Recommendation 10Further planning reform and increased incentives are urgently required to boost housing supply.

Chart 15 – UK housing supply

0

10000

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50000

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90000

Q1/1978 Q4/1979

Q3/1981 Q2/1983

Q1/1985 Q4/1986

Q3/1988 Q2/1990

Q1/1992 Q4/1993

Q3/1995 Q2/1997

Q1/1999 Q4/2000

Q3/2002 Q2/2004

Q1/2006 Q4/2007

Q3/2009 Q2/2011

Q1/2013 Q4/2014

UK: Housing Completions: United Kingdom: Total (NSA, Number) - Seasonal Adjustment, All

Source: DCLG


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Recommendations

Recommendation 1: Loosen fiscal policy to support growth and take the strain off monetary policy.

Recommendation 2: Stimulus should be designed to support long-term growth through targeted reform and infrastructure investment.

Recommendation 3: Fiscal rules should be flexible and permit borrowing for investment through the cycle.

Recommendation 4: A fiscal stimulus of 1.25% of GDP would help cushion the short-term impact of EU exit and provide funding for long-term growth boosting policies.

Recommendation 5: Calibrate fiscal policy over the rest of the parliament on the performance of the economy.

Recommendation 6: Stimulus should focus on public investment, departmental spending and welfare spending to generate the best short-term return. Direct or indirect tax cuts would represent a weaker stimulus.

Recommendation 7: Increased infrastructure spending should be targeted at the UK’s deficiencies in road and rail transport. Spending should address local, small-scale infrastructure improvements rather than grand projects. The government should grant full independence to the National Infrastructure Commission to avoid spending being influenced by party politics or the electoral cycle.

Recommendation 8: The government should aggressively implement the recommendations of its reviews on early child intervention and vocational skills. Greater funding should be directed to these priorities.

Recommendation 9: Inefficiencies in the tax system should be actively addressed. In the first instance, the government should target small changes in capital allowance and set out a stable and consistent tax system for the financial sector. More ambitious goals should include a tax allowance for corporate equity and reform to business rates.

Recommendation 10: Further planning reform and increased incentives are urgently required to boost housing supply.


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