Britain is in a deep investment hole. Public expenditure is due to fall regardless of who wins next month’s election, while business spending is also at a low ebb.
To dig the country out of its investment crisis, the party that wins national elections on July 4 has a range of options that could fudge counterproductive fiscal rules.
The policy blueprints published by the ruling Conservatives and opposition Labour Party ahead of the election are long on buzzwords. The former’s manifesto pledges “bold action”; the latter’s advocates something called “securonomics”. But they’re short on detail, for a good reason: the numbers don’t add up.
Between 2010 and 2023, UK output expanded by an average of 1.6% a year, well below the 2.2% pace between 1979 and 2010. UK GDP will grow by just 0.5% this year, compared to 2.7% in the United States and 0.8% in the euro zone, the International Monetary Fund forecasts. GDP per capita is now lower than before the 2019 election.
The key reason for this stagnation is a collapse in productivity – the output created for each hour worked. The London School of Economics’ Centre for Economic Performance found that productivity now is 26% lower than if it had followed its trend between 1979 and 2007. It’s also below the U.S., Germany and France. The LSE research shows that Britain’s workers didn’t receive enough capital – technology, training and machinery. In other words, underinvestment is holding back the UK economy.
Business investment, which accounts for more than half of UK spending that doesn’t go on current needs, is around 10.5% of GDP. That ranks an abysmal 28th among the 31 countries in the OECD, according to the Institute for Public Policy Research. And government investment spending has been around 2.5% of GDP on average since 1995, below the 3.4% averaged by G7 advanced economies, the LSE found. Worse, fiscal forecasts set by the current government – and largely embraced by Keir Starmer, leader of the opposition Labour Party – imply public sector investment will actually decline from 2.4% of GDP this fiscal year to around 1.8% in 2028-2029, according to the Institute for Fiscal Studies.
That fall – equivalent to a cut of around 26 billion pounds – is the opposite of what Britain needs. Its schools are falling apart and the UK transport network requires a 22 billion pound upgrade, according to the National Infrastructure Commission. The new government will also have to find ways of encouraging private investment. Fighting climate change alone will cost up to 35 billion pounds a year in private sources of capital until 2050, the NIC said.
The new government, most likely led by Starmer, will have two natural options to deal with these issues: higher taxes or more borrowing. The manifesto says that by 2028-2029 Labour would raise 8.6 billion pounds from the likes of windfall taxes on oil and gas companies and VAT on private schools. But around 5.2 billion pounds would come from reducing tax avoidance – a measure often invoked but rarely achieved by would-be prime ministers.
Those revenues aren’t even enough to cover Labour’s spending plans of around 9.5 billion pounds a year to pay for measures such as carrying out 40,000 more weekly operations, scans and medical appointments and to create a “Great British Energy” company to fund renewables. And they are certainly not enough to make up for the Conservatives’ decision to leave a future shortfall of up to 20 billion pounds a year in public spending across most government departments, according to the IFS. “Protected” areas, including health, defence and education, will receive cash injections, but such an outbreak of austerity would still hit Britain’s public services hard.
Starmer and the likely finance minister, Rachel Reeves, have promised not to hunt the big beasts in the fiscal jungle: income tax, corporation tax, VAT and national insurance. They could increase other levies, such as the ones on capital gains or inheritances, but their room for manoeuvre is limited. That’s because the current government has already decreed tax rises of 23 billion pounds a year by 2028-2029, according to the Resolution Foundation. Those will further increase Britain’s tax-to-GDP ratio from the current 36.5% – the highest since 1949.
The borrowing route is full of roadblocks too. The biggest one is Labor’s pledge to abide by the Conservatives’ rule that public sector net debt as a percentage of GDP must fall at the end of a five-year rolling period. At present, that leaves the next finance minister with less than 9 billion pounds in extra borrowing capacity by 2028-2029.
It’s imperative that Starmer and Reeves avoid unsettling markets in the way former Prime Minister Liz Truss notoriously did in 2022. But there’s scope to scrap the arbitrary debt reduction rule and replace it with a fiscal ceiling that is both tough enough but sensible enough to enable investment-focused borrowing. There are three viable options.
The first, and simplest, is to target “headline” public debt, instead of “underlying” public debt. The former takes a more lenient view of the Bank of England’s losses on its bond portfolios. As a result, it would give the next government nearly 25 billion pounds in extra borrowing, according to Goldman Sachs.
The second option would be to introduce European-style loopholes. The European Union’s new fiscal rules enable governments to dodge them if they spend money on pro-growth investments. The problem is that while messy compromises are second nature in the EU, the UK’s fiscal space is policed by the independent Office for Budget Responsibility. The risk is the OBR plays a similar party-pooper role to Germany’s Constitutional Court, which last year pegged back Berlin’s investment plans.
The third, and most radical, option would be to target “public sector net worth”. That yardstick uses corporate accounting methods to measure the difference between the state’s assets and its liabilities. Using that metric would give Starmer nearly seven times more fiscal firepower than he has now, according to the OBR.
The Labour manifesto does say that the current rules are “non-negotiable”. But faced with the reality of government, Starmer and Reeves may decide that a fiscal U-turn that delivers some 60 billion pounds in extra spending is better than chronic underinvestment, crumbling public services and a stagnant economy.
