What are fiscal rules and how have they worked in the UK?

Since the 1990s, UK governments have set constraints on how much they can borrow to fund public spending net of tax revenues, as well as total public debt relative to GDP. These targets are required by legislation but have been frequently adjusted in response to changing circumstances or priorities.

A fiscal rule is a limit or restriction adopted by governments to constrain their decisions around taxes and public spending (Institute for Government). Such rules have generally been self-imposed, but they could easily be set by an independent body. They typically apply to a measure of the fiscal deficit (the gap between public expenditure and tax revenues in a given year), the public debt (the total amount borrowed to finance past deficits) or public spending (in aggregate or a subset) relative to GDP.

Governments in the UK have used fiscal rules to guide policy since 1997. During that time, public debt relative to GDP has risen materially as a consequence of major economic shocks. Commentators have become increasingly concerned that the rules have created incentives for poor policy-making (that is, chancellors have focused on meeting the letter rather than the spirit of their fiscal rules) and are now being gamed.

How have UK fiscal rules worked in practice?

Although fiscal rules have dominated the narrative, they are only a part of what governs fiscal policy-making in the UK. The wider political and institutional contexts are also important.

In particular, the political economy of fiscal policy in the UK – where power lies in terms of tax and spending decisions – involves governments that are strong relative to parliament, and a Treasury that is strong relative to other departments. These features of the UK’s ‘fiscal constitution’ are explored in depth in Hood et al, 2023.

Perhaps the most important recent evolution in this set-up was the creation of the Office for Budget Responsibility (OBR) in 2010, which removed from the Treasury its ultimate control over the forecasts that underpin fiscal policy.

As a result, fiscal rules should be seen as an expression of a government’s objectives, not something that dictates those objectives. Further, it is relatively simple for a government in the UK to change its fiscal rules – a feature of increasing concern in recent years as fiscal rules have been changed more frequently by the chancellor of the day.

Finally, while it is clear that rules are gamed at the margin, they also force governments to recognise fiscal constraints – the limits on borrowing to allow public spending to exceed revenue – and to confront the resulting need to make trade-offs between different priorities. In practice, while the fiscal rules that have been pursued in the UK may not have been perfect, their absence from future fiscal governance would probably be worse (Tetlow et al, 2024).

Why do governments set fiscal rules?

Fiscal rules have become increasingly popular around the world in recent decades. The latest count by the International Monetary Fund (IMF) found that around 105 countries had at least one fiscal rule (IMF, 2022).

In one way or another, these rules are supposed to constrain the discretion of governments. This idea of constrained discretion first gained traction in research on monetary policy (Rogoff, 1985) before being applied to the fiscal policy arena (Alesina and Tabellini, 1990).

Why would government seek to constrain their discretion over policy choices? They do this to overcome a problem of time inconsistency known as ‘deficit bias’. This is the tendency of governments to spend more or tax less than would be optimal if appropriate weight was placed on the interests of future generations who will pay for the fiscal deficits that benefit today’s voters. Fiscal rules can also improve coordination with monetary policy (Chadha, 2023).

The equivalent concept in monetary policy is ‘inflation bias’: the tendency to run the economy too hot for short-term political gain. On time inconsistency in policy-making more generally, the classic reference is Kydland and Prescott, 1977.

What causes deficit bias? One study summarises six related issues: ‘(i) informational problems; (ii) impatience; (iii) exploitation of future generations; (iv) electoral competition; (v) common-pool problems; and (vi) time inconsistency’ (Calmfors and Wren-Lewis, 2011).

How has constrained discretion over fiscal choices worked in the UK?

In the UK’s institutional setting, fiscal policy choices are dominated by the executive over parliament, and by HM Treasury within the executive. In this context, it is crucial to understand that the most important source of fiscal discretion is the chancellor’s ability to choose – and revise – fiscal targets.

The UK has had formal fiscal rules in place since 1997. The first set outlined that the government would only borrow to invest and not to fund current spending (the ‘golden rule’), and that the ratio of net public sector debt to GDP would not exceed 40% of GDP (Institute for Fiscal Studies, IFS 2006).

These rules lasted more than a decade before being abandoned in 2008 due to the global financial crisis. Since then, targets have been changed frequently – typically linked to events, like the Brexit referendum or energy crisis, or to changes in government or chancellor. By the Institute for Government’s count, there have been nine sets of fiscal rules in all, with the UK changing its targets more frequently than any other country (Tetlow et al, 2024).

Once targets are in place, they constrain discretion at the margin. In effect, their role is to establish how much a government can spend given how much it is willing to raise in taxes. But fiscal targets reflect a government’s fundamental fiscal choices: they do not determine them.

The austerity policies in place under George Osborne’s chancellorship, 2010-15, were not driven by fiscal targets. Rather, his fiscal targets were a reflection of the coalition government’s judgement that deficit reduction was ‘the most urgent issue facing Britain’ (HM Government, 2010). In other words, the fiscal strategy of reducing the post-financial crisis budget deficit more quickly than the outgoing Labour government had planned was a decision taken before settling on a precise design for the fiscal targets that the coalition government then pursued.

The increasingly frequent changing of fiscal targets in recent years shows how they can be flexed to accommodate other objectives – including those forced on governments by external shocks and their aftermath. The ease with which chancellors can change fiscal rules in the UK means that there is a limit on the extent to which they constrain fiscal policy choices.

The underlying features of fiscal targets in the UK

Despite the growing number of fiscal targets that have been pursued, there are some features that have been relatively constant throughout. For example, other than the brief ‘temporary operating rule’ in place during the global financial crisis of 2007-09, they have all targeted public sector net debt alongside a measure of the deficit relative to GDP (HM Treasury, Pre-Budget Report, 2008).

The main change was to shift from targeting the level of the debt-to-GDP ratio under Gordon Brown’s ‘sustainable investment rule’ to the year-on-year change in the debt-to-GDP ratio under every debt target since George Osborne’s first ‘supplementary debt target’. (See the discussion in chapter 4 of the OBR’s October 2021 Economic and Fiscal Outlook.)

What drove that key change? This is in some ways an accident of history and ‘path dependency’ – when events or choices affect later events and choices. It is not clear whether the relative merits of targeting the level versus the year-on-year change in the debt-to-GDP ratio have been reviewed since the switch was made in 2010.

After the global financial crisis – in a context of huge economic uncertainty over the extent to which the supply side of the economy had been damaged – the Treasury’s first priority was simply to turn the debt-to-GDP ratio around. In other words, the focus was on bringing the deficit down far enough that debt would stop rising relative to GDP. That was expected to take many years – as indeed it did.

Through the 2010s, in an era of very low interest rates, there was no meaningful limit on the total level of debt, as the rate of interest was below the rate of economic growth. Indeed, a Treasury survey of various estimates found a range from 167% to 223% of GDP (see box 2.F in HM Treasury, 2018).

Consequently, targeting the need to get debt falling while remaining agnostic about its level continued. Today, with interest rates on government debt back up to around 4%, the level of debt matters more.

Back in the 2000s, the Treasury published a book about its reforms to the macroeconomic framework – known inside the Treasury as ‘the Silver Book’ (Reforming Britain’s Economic and Financial Policy, 2002).

In the chapter on debt, it explained that while there is no agreed way of picking an optimal level of public debt, there are pragmatic reasons to want it to remain low in normal times. It illustrated how aiming to keep debt at 40% of GDP meant that if a major shock were to hit, debt would still be at a relatively manageable level even if it were to double to 80%.

Just a few years later, the global financial crisis caused public sector net debt almost to double from 36% of GDP in 2007/08 to 65% of GDP in 2009/10 (OBR Public Finances Databank). It currently lies at just under 100% of GDP.

The fiscal targets today

In the 2023 Fiscal Risks and Sustainability Report, the OBR showed that if shocks – such as the Covid-19 pandemic – were to continue to push debt higher periodically, with a similar intensity as experienced so far this century, it would be necessary for governments to aim to have debt falling by 2.5% of GDP a year on average before the event (ex ante) for it to remain stable in the aftermath (ex post). But the key to reducing debt to GDP is growth.

In fact, despite higher levels of public debt after the shocks of the past 15 years – and higher interest rates – the UK now has the loosest set of fiscal targets since 1997.

As has been the case since 2008, there is no ceiling placed on the level of the debt-to-GDP ratio. At the same time, the target year by which debt must be falling has been pushed out to the fifth and final year of the medium-term forecast period. This means that the debt-to-GDP ratio can grow for four years providing it falls in year five, and so it is now possible for a government to meet its fiscal rules with an increasingly unsustainable level of debt to GDP.

In addition, the limit on the fiscal deficit is 3% of GDP, with no requirement to maintain public investment or to limit non-investment (or ‘current’) borrowing within the total.

Have fiscal targets been a cause of poor policy decisions?

There has been increasing criticism of fiscal targets as a driver of poor decisions. This applies both at the macroeconomic level – in terms of overly tight fiscal policy when interest rates were at the zero lower bound (Portes and Wren-Lewis, 2015) – and at the microeconomic level – for how they influence individual policy decisions (such as the initial decision to make full-expensing of business investment costs a temporary measure (Tetlow et al, 2024).

Perhaps most important the fact is that they might have played a role in holding back public investment and research and development (R&D).

All fiscal targets are gamed to some extent. Once a boundary has been set, an incentive is created to push that boundary. During the era of the golden rule, from 1997 to 2008, when the Treasury rather than the OBR was responsible for forecasting, there was a suspicion that the revenue forecast was massaged to help to meet the rules (or ‘fixing the figures to fit the budget’ in George Osborne’s words, Queen’s speech economy debate, June 2010).

Similarly, the dates of the economic cycle over which the rules were assessed were amended at a key moment (HM Treasury, Dating the economic cycle, 2005 – no longer accessible on the Treasury website).

Now that the OBR is responsible for the forecast, chancellors must change policies to meet expected fiscal targets. When combined with the fact that chancellors place considerable weight on the precise amount of headroom that they have against their targets (that is, the margin by which they are predicted to be met in the OBR’s central forecast), this has indeed led to a degree of fiscal fine-tuning – as well as some less than realistic assumptions about future policy.

These unrealistic assumptions have recently become known as ‘fiscal fictions’. The chancellor says that fuel duty will be raised in line with inflation after being frozen for a single year – but that one-year freeze has been extended for another year every year since 2011 (Treasury Select Committee, 2023).

More significantly right now, the fiscal targets are met on the basis of total envelopes for spending on public services that are very tight and have not been allocated out to individual departments beyond April 2025. These plans are widely viewed as close to undeliverable (King, 2024). Fiscal reality will bite after the election.

Fiscal targets do force governments to make trade-offs

By establishing the overall envelope for public spending given choices that have been made about taxes, fiscal targets force governments to make choices: if we want to spend more on x, we can either spend less on y or raise taxes on z.

Some of the choices made over the past couple of years have attracted criticism – the initial temporary nature of full-expensing being a prime example. Was that the fault of the fiscal targets? Or was it simply the government’s choices that commentators didn’t like?

For example, the chancellor could have made full-expensing a permanent policy from day one within the constraints of his fiscal targets by taxing something else more heavily. In the end, a favourable forecast revision at the Autumn Statement later in the year meant he could make it permanent without having to find an offsetting policy saving.

Fiscal reality rather than fiscal targets is the biggest challenge today

The difficult choices that governments have had to make – and the even more challenging ones likely to face the next government given the squeeze on public services implied by the spending path set in the 2024 spring budget – are ultimately the result of fiscal reality rather than fiscal targets.

As noted, the current fiscal targets are loose by historical standards. And yet painful trade-offs have had to be made and more painful ones are in prospect. Why? Because growth has been poor.

Deep down, this reality reflects subdued economic prospects – in particular, the far weaker outlook than that on which past fiscal plans were conditioned. David Miles (Imperial College London and a member of the OBR budget responsibility committee) has argued that the economy today is plausibly almost 30% smaller than a forecaster might have expected looking forward from 2007 (see Q10, Treasury Select Committee, March 2024).

Shocks have continued to hit: both external ones like Covid-19 and the energy crisis; and policy-induced ones like Brexit. The pressure that these place on prospects for growth in tax revenues comes at the same time as demand for spending on healthcare, age-related services and investment in net zero is rising. Altogether, this means that demand for public spending outweighs the ability of the tax base to finance it.

Where can I find out more?

Strengthening the UK’s fiscal framework: Putting fiscal rules in their place: Institute for Government report by Gemma Tetlow, Olly Bartrum and Thomas Pope.
Fiscal risks and sustainability – July 2023: Report from the OBR.
How the OBR can help people understand the implications of government’s stated spending plans: Article for the Institute for Government by Andy King.
Fiscal rules in the UK since 1997: Article by Thomas Pope and Peter Hourston.
The missing link: modelling potential output at the Office for Budget Responsibility: Article by Jagjit Chadha, director of the National Institute of Economic and Social Research (NIESR).
Designing a new fiscal framework: understanding and confronting uncertainty: NIESR report from 2021.
The UK’s post-Covid fiscal rules: Summary of views of UK economic experts surveyed by the Centre for Macroeconomics and reported by Ethan Ilzetzki at VoxEU.