The author, a contributing editor to the FT, is the managing director of the Royal Society of Arts
Last month, I discussed the negative feedback loop between stalling economic growth and expanding safety nets. How do countries break free from this “cycle of fate”? An important element is to rethink the tax rules that shape government investment decisions.
The idea of tax rules, which put limits on government borrowing, is a good one. Governments should abide by the “good ancestor” principle, equipping future generations with goods and income, not burdening them with debt and taxes. In this way, fiscal rules can help ensure intergenerational fairness: they are the day-to-day equivalent of leaving your children with a home rather than a mortgage.
After a string of pandemic-related lunatics in government spending, fiscal rules are now in serious risk of being breached. Next month, the United States will face a precipice due to the debt limits imposed by Congress. In the EU, the calibration of the Stability and Growth Pact limits on countries’ debt is proving harsh. And in the UK, fiscal rules that mandate a declining debt-to-GDP ratio within five years are limiting the government’s ability to implement long-term growth-boosting policies.
Do these rules exercise useful fiscal discipline or limit investment and growth? I believe the latter. They are typically based on the stock of government debt relative to income. We would expect this ratio to vary over time. The greater the challenges a nation state faces, the stronger the opportunity for debt-financed investment in the public goods needed to meet them.
Take the UK. Since the Industrial Revolution, the ratio of debt to gross domestic product in the UK has, on average, doubled every century. This was an explicit choice by society to invest in the new sets of public goods needed to support economic and social progress, from schools to housing to healthcare. Other countries’ debt-to-GDP ratios have also tended to rise over time.
We shouldn’t necessarily expect this pattern to repeat itself in the 21st century. But neither should we expect debt-to-GDP ratios to flatten or decline. Many advanced economies are facing challenges no less serious than those faced by our ancestors. And the argument for a new set of public goods to satisfy them is just as compelling.
This highlights a second flaw of existing tax rules: they are typically based on net financial debt. They do not recognize non-financial assets created by public investment, whether they are tangible (roads, hospitals, schools) or intangible (intellectual property, data, code). Nor do they recognize investments in natural assets, such as clean water, air and a thriving biosphere.
Recognizing those assets would give us a measure of the government’s true net worth. Just as a business or household would look at its net worth when making investment choices, so too should the government. High net worth countries have been found to have lower financing costs. Bond market vigilantes target poor ancestors, not borrowers. This is why real government borrowing costs have tended downward over the centuries, despite government debt ratios trending upwards. The financial markets know that it’s the value of the home, not the mortgage, that matters.
Countries with higher net worth also tend to exhibit greater macroeconomic resilience. This therefore reduces the burden on the state when adverse shocks occur. Our current debt-based fiscal rules, by limiting public investment, have contributed to a reduction in macroeconomic resilience and an increase in the safety net following shocks.
This has been the story in recent decades, when G7 government investment has remained flat or declining, despite global real interest rates approaching zero. This was an opportunity to invest in economic and environmental regeneration and stimulate growth and macroeconomic resilience. Wrong tax rules meant it was wasted and the vicious cycle continued.
Since then global real yields have increased around the world. But with real rates still below 1% globally, the cost-benefit calculation would overwhelmingly favor public investment today to support growth and resilience tomorrow. Recent skirmishes over debt limits in advanced economies mean that this opportunity is once again in danger of being squandered.
Compliance with existing tax rules risks underinvesting today in tomorrow’s economic and environmental health. As evidence over the past decades has shown, debt-based fiscal rules dent growth, weaken macroeconomic resilience and amplify the vicious circle. Future generations will rightfully consider us bad ancestors if we remain true to them.
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