What’s the economic inheritance of the new UK government?

The Labour government will present its first budget in late October. The new chancellor has inherited an economy with at least four big problems: low productivity growth; stagnant living standards; persistent regional inequality; and a fiscal framework that is stifling much-needed public investment.

The new government has inherited an economy facing a number of challenges. These include low productivity growth, stagnant living standards and a tax burden at its highest since 1949.

Meanwhile, public services are under significant strain, infrastructure is in need of investment, defence spending is expected to rise due to elevated geopolitical risk, and the transition to net zero requires significant green investments.

Low productivity growth

Growth in UK labour productivity – a measure of how efficient workers are – has been declining notably over time. Between 1947 and 1973, the country’s trend output growth rate was 3.4%. But this measure of the rate at which good or services produced in an economy is increasing slowed to 2.3% in the years leading up to the global financial crisis of 2007-09.

Then, from 2010 to 2023, the UK economy grew by an average of just 1.5% annually. What’s more, prior to the crisis, the UK average growth rate was much closer to the OECD average of 2% – it now sits consistently behind.

With further declines in economic growth after Brexit, analysis suggest that the UK’s exit from the European Union’s (EU) single market inflicted a permanent economic loss on the country. GDP is projected to be 5-6% lower than it otherwise would have been by 2035 (Kaya et al, 2023).

While annual UK productivity growth is now only slightly above 1% post-Covid-19, and well below historical standards, raising this ought to be a priority for the new government.

Another key factor contributing to sluggish economic performance and a slowdown in productivity growth is the low levels of investment in the UK economy more generally. Business investment has consistently been below that of comparable OECD economies, and public investment also lags behind.

Addressing the UK’s economic challenges will require sustained increases in both public and private investment, particularly in areas like green technology. The new government’s plan to establish Great British Energy, a state-owned company focused on clean energy, is a positive step, but it does not go far enough.

The government will also require bolder action on fiscal rules – government-adopted limits on taxes and spending – if it is to make significant changes to boost the levels of public investment needed for the UK economy to increase its trend rate of growth.

Public investment and fiscal constraints

While the UK economy has been marred by stagnant growth in output, this poor economic performance also puts pressure on the public finances and reduces fiscal headroom (the amount of money available for spending or tax cuts given the fiscal rules).

This has direct economic consequences by limiting the government’s ability to invest in crucial areas like healthcare, education and infrastructure. Investments in these areas are required to increase the long-run potential output of the economy.

Meanwhile, competing demands for government spending – such as the need to improve public services, infrastructure and defence, as well as the green transition – all further constrain the limited fiscal space.

The current fiscal framework exacerbates these issues by prioritising short-term reductions in the ratio of public debt to GDP over long-term investments. Specifically, the fiscal rules mandate that public debt must decrease as a percentage of GDP by the end of a five-year horizon.

This has the effect of discouraging investment projects with long-term payoffs. Research indicates that public investments often take much longer than five years to yield returns, yet the fiscal rules treat these investments as expenditures without immediate benefits (Chadha, 2021).

The new chancellor has proposed revising the deficit rule to balance the current budget while allowing for borrowing to fund investment. This supposedly eases the constraints on public investment. But this reasoning does not hold as the debt rule remains unchanged. This is because the debt rule states that debt-to-GDP ratio should be falling within a five-year horizon.

Subsequently, any project that does not increase output and lower this ratio within five years is at odds with the Treasury’s fiscal mandate. This discourages public investment by excluding the impact of projects that would lower the debt-to-GDP ratio beyond the five-year window. Consequently, it is the debt rule that acts as a constraint to public investment, not the deficit rule.

Therefore, merely tweaking the fiscal rules will not create enough space for the necessary investments in public infrastructure. Instead, comprehensive reforms are needed, including discounting public investment from fiscal targets, incorporating a measure of public sector net worth, and adopting a more flexible approach to public debt.

Public finances and the national debt

The UK national debt has increased dramatically following the global financial crisis, rising from 37% of GDP in 2007 to 79% in 2014. A similar spike occurred during the pandemic, bringing the debt-to-GDP ratio just above 100% (inclusive of debt held by the Bank of England).

Despite these significant increases in the stock of public debt, historically low interest rates after 2008 helped to manage the servicing costs (repayments including interest) of the higher debt load. Specifically, the Bank of England absorbed most of the new debt issued between 2009 and 2021, which helped to ease pressure on the bond market.

But in recent years, monetary policy has been tightened to deal with above target inflation. The implication is that the new government faces much higher borrowing costs, adding significantly to the already heavy fiscal burden.

While some modest increases in spending under the new government will generate some additional growth, it is unlikely to be enough to lower the deficit significantly. Subsequently, the deficit is projected to remain above 3% of GDP for the next five years – even if public investment is excluded in line with the chancellor’s new deficit rule.

As a result, it is highly likely that the government will not meet its own self-imposed fiscal rules, further raising questions about the sustainability of its proposed fiscal policies.

Living standards and income inequality

Low productivity growth has naturally filtered through into relatively poor wage growth. For example, between 2009 and 2019, net earnings growth in the UK was among the lowest in the EU, leaving households more vulnerable to economic shocks such as, Brexit, Covid-19 and the energy price shock following the Russian invasion of Ukraine in 2022.

Real equivalised household disposable incomes are estimated to be lower across the board in 2024-25 compared with 2019-20, with the poorest tenth of households seeing a 20% decline in their living standards.

Government measures to mitigate the impact of rising energy costs and inflation, such as cost-of-living payments, have not been optimally targeted. As a result, these measures have been regressive, as higher-earning households (those in the top income deciles) received more support than those with lower incomes in level terms, thereby exacerbating inequality. What’s more, middle-income households, which do not qualify for welfare benefits but also have relatively low earnings, have been disproportionately affected.

Tax and welfare policies ought to be more targeted to support these households in the middle. For example, increasing the tax-free personal allowance could ease the financial pressure on those not eligible for welfare, while targeted productivity-enhancing policies such as training grants could help to increase earnings potential. In addition, the government could consider raising the repayment threshold for student loans to alleviate the financial burden on recent graduates.

But the available headroom to tackle these challenges remains constrained by two key factors: economic performance and the fiscal rules.

Conclusion

The new government has inherited an undoubtedly challenging economic situation. Low productivity growth, fiscal constraints and stagnation in real household disposable income all require urgent attention.

Raising productivity through sustained public and private investment, especially in green technologies, should be a top priority. But to achieve this, it is likely that the government will need to reform its fiscal rules significantly. This will allow for long-term investments that can drive economic growth, increase the long-run productivity potential of the economy and improve living standards across the country.

Where can I find out more?

The aspiration for public investment: August 2024 report from the National Institute of Economic and Social Research (NIESR).
Rethinking regional regeneration: September 2024 piece by NIESR deputy director Adrian Pabst.
Fiscal rules and investment in the upcoming Budget: September 2024 report from the Institute for Fiscal Studies.