Rachel Reeves warned over ‘fiscal illusions’ in new debt rule

Rachel Reeves could exploit “fiscal illusions” thrown up by the new government debt rule that allowed the chancellor to boost borrowing by £28 billion in the budget, the spending watchdog has warned.
In an explanation of the potential pitfalls and benefits of the new debt definition contained in its economic forecasts released last week, the Office for Budget Responsibility said that the chancellor might also see the bulk of her £16 billion of fiscal headroom wiped out by weaker stock prices.
The OBR claimed that the government could be incentivised to make “low-quality loans” that turn out to be overvalued, thereby hiding underlying risks in the public finances.
Some loans captured under the new accounting framework announced by Reeves at the budget are scored as an asset on the government’s balance sheet “regardless of the probability of repayment”, the OBR said.
As a result, the chancellor could “be tempted to exploit these fiscal illusions and undertake policies that move a fiscal aggregate favourably while worsening fiscal sustainability”, the UK’s official forecaster said.
At the budget last week, Reeves announced that the government would target a new debt measure, public sector net financial liabilities (PSNFL), within its fiscal rules. The measure, which captures a range of financial public assets, such as equity stakes in companies and student loans, must initially be falling as a share of GDP in five years before that time frame is narrowed to three years.
It means that, in theory, the government could make loans to companies which are netted off its new debt measure. Some of these loans would retain their full value on the government’s balance sheet but could never achieve their expected returns, meaning that “the genuine value of the loan book will be exaggerated”, the OBR said. The watchdog provides estimates of these written-off loans.
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PSNFL does not account for physical assets, which Nick Winters, partner at Blick Rothenberg, an accountancy firm, said could steer the government towards investing in financial assets rather than directly into public goods such as schools and hospitals.
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Ben Zaranko, a senior research economist at the Institute for Fiscal Studies, said that “there might be an incentive to do physical investment under the guise of financial investments, so as to have the financial asset netted off the debt measure, but I struggle a little to see how that would work in practice”.
Under PSNFL, assets held by public sector pensions are also included, a large proportion of which are equities. The OBR said that if equity prices grew two percentage points less than nominal GDP growth then, all else being equal, it would subtract £10 billion from Reeves’s £15.7 billion of fiscal headroom.
This tweak to the debt definition expanded the margin against which Reeves would hit her fiscal targets by about £50 billion, £28 billion of which she used to increase borrowing to finance the biggest public investment drive since the 1980s.
She also lifted taxes by £40 billion to sharply increase public spending in the short term. As a share of the economy, the tax raising measures were the largest at a single budget.