Why the Chancellor’s plan to commit billions of pounds of public investment is such a gamble

Perhaps the most important long-term change announced in Labour’s first budget is the new rules the government has introduced to fund the expansion of public services and increased public investment. These fiscal rules, which determine how much the government can borrow and spend, are considered critical to reassuring markets and the public that the government is managing the economy wisely.

The Labor Party has long argued that former Prime Minister Liz Truss’s scrapping of rules to introduce unfunded tax cuts in 2022 destroyed the British economy and left families worse off through higher mortgage and borrowing costs. Chancellor Rachel Reeves took office determined to demonstrate that the Labor Party would be fiscally responsible.

The government says this budget will improve the well-being of working families. Its own analysis shows that the plans only made the top 10% of the income distribution worse off (by 1%). The poorest households receive the most (by 5%). However, this analysis takes into account the benefits of large increases in government spending on areas such as health and education, which tend to be used by poorer households (relative to their income).

Actual cash income shows a different picture. The Office of the Budget Review (OBR) says 75% of changes to employers’ national insurance will be passed on to lower-paid workers (although the minimum wage will rise by 6.7% to £12.21 an hour). And there was very little universal credit for the working poor and those outside the labor market (although pensioners were protected).

This budget comes against the backdrop of two big problems requiring urgent action: the dire state of the public sector after years of austerity and the very slow growth of the UK economy, which has meant little increase in real incomes.

To address these two problems, Reeves made some big changes to the previous government’s fiscal rules. That would give it the ability to borrow more money to finance public investment—spending on things like roads, hospitals and emerging industries that should fuel economic growth.

Looking for money

She did this by first changing what is known as the “fiscal mandate,” which refers to how much the government can borrow in any given year. Under the new rule, within three years the government must get back as much in taxes as it spent (not including investments).

It is the need to comply with this rule that means the government must raise taxes by £40 billion (more than half of the increase in employers’ National Insurance contributions) to fund the costs needed to run the National Health Service, education and other public services.

But the government has another rule to prevent the total amount of government debt from becoming too large relative to the size of the overall economy (GDP). Here, the Chancellor decided to change the definition of government debt by adding some more government financial assets, such as money set aside for local government pensions and student loans, to offset the outstanding loan amount.

This has given it the ability to borrow an extra £50bn a year for investment, although it only plans to use half that amount. The hope is that increased government investment will stimulate the economy (through more roads and clean energy, for example) and also improve public sector productivity (through more schools, health centers and scanners).

The OBR concluded that Reeves would comply with its self-imposed rules within three years, despite a huge £70 billion increase in government spending. But he cautions that the margin for error is very small for both measures. The OBR also suggests that the economic benefits of increased public investment may take a long time to be realized, well beyond the five-year forecast period.

There are other risks to Reeves’ strategy. Borrowing costs could rise if the financial institutions that lend to the government demand higher interest rates.

The OBR predicts the government will spend £100 billion a year on debt interest payments over each of the next five years. While a large increase in government spending and borrowing will initially stimulate the economy, it also means that inflation is likely to remain slightly higher as more money is pumped into the economy. This, of course, could slow the pace of the Bank of England’s interest rate cuts.

The gains for the population as a whole over the parliament’s five-year term appear modest, with the second-highest rise in household income of any recent parliament at just 0.5%. This comes as the OBR forecasts that the budget will not initially stimulate growth much, despite increased borrowing.

And if the economy doesn’t grow as quickly as hoped, the government may need more money to cover its day-to-day spending – especially since much of the new money has already been committed in advance and will be spent over the next two years. This will definitely lead to even higher taxes.

The fiscal rules reflect the Labor Party’s political dilemma, the need for short-term pain to reap long-term benefits from improved public services, a more productive economy and higher incomes and living standards. It is unclear how long the public will wait for results.

If by the end of Parliament people don’t feel they have more money in their pockets, despite all the extra spending, then Labour’s credibility could be at risk.