How to "recognise the benefits of investment" and unlock local growth

Last week, Rt Hon Rachel Reeves said in her conference speech,

...it is time that the Treasury moved on from just counting the costs of investments, to recognising the benefits too.

This gained a lot of media attention. For example, it was covered by Fran Boait for LBC, by Oli Smith in the Daily Express and Mehreen Khan and OLIVER Wright in The Times. It also prompted a post on the Institute For Fiscal Studies website. The comment and the IFS post were then the subject of a conversation between Mehreen Khan and Edward Stourton on The World At One, which I listened to on Friday.

This issue of how the Treasury does its counting and presents the numbers is a subject I've had a passionate interest in for well over a decade now. I've researched some aspects of it extensively. As soon as I heard this discussed last week, I was therefore keen to put together a post on it. I hope you find this thought-provoking. Needless to say, I would be very happy to work with the Government and/or other interested parties on this, in whatever way is appropriate.

Avoiding too narrow a focus – working from problem to solution

The IFS post argues, quite convincingly, that the Government needs to make the case that borrowing for extra investment would drive growth and make the public finances more sustainable. This case needs to be made to the public and the gilt markets.

This would suggest that the Government starts from this principle and Reeves’s diagnosis of the problem. They would then identify changes to the way the Treasury manages and measures the public finances, that flow naturally from these points. Unfortunately, both the IFS post and the World At One discussion focus narrowly on rather technocratic changes to the primary measure of debt.

As I argued in Building Freedom, it is far better to:

• Start from an honest acknowledgement of the current relationship between the various parts of the public sector and how the Government would like to see these develop;
• Consider Treasury and OBR procedures and their analysis and presentation of the public finances in the round;
• Work logically from the diagnosis of the problem to the course of action for reform.

Across the world, governments use many different measures of debt and deficit. But, as explained in Building Freedom, these are used within widely differing governmental cultures and differing presentations of the public finances. The design of fiscal documents also has an impact on the way the constituent parts of the public sector operate, and this needs to be considered alongside any changes in primary measures of debt and deficit.

The meaning of investment and calculating a return

So what does this mean in practice? Well, let’s start from Reeves’s point about recognising the benefits of investment. A key problem here is what is meant by “investment”. The Treasury, OBR and IFS tend to use “investment” as a synonym for “capital expenditure” – that is, spend which increases the value of physical or financial assets. (This can be seen, for example, in the OBR report referred to in the IFS article.)

But this isn’t what’s generally understood by the term. If you were to ask someone from the financial services sector what “investment” means, they would say something like “making a payment which provides a future income which is greater than the initial outlay in real terms”. This would be more-or-less what the general public would understand by the term. But not all capital expenditure is necessarily an investment. There may be many cases where Government spend on an asset does not provide any future tax receipts; they do it because it’s the right thing to do to improve citizens’ quality of life. And, crucially, not all investments are capital expenditure. A lot of spend on public sector recruitment and pay, for example, will provide a return to the Exchequer over time.

The new Government really seems to have understood this point – for example, by recruiting new tax compliance officers and by looking at ways of supporting people into work. (I’ll say more on this last one in a forthcoming post.)

The first revision that's needed here is a change to the language used in fiscal documents to acknowledge that revenue spend can be investment. But beyond this change of terminology, we need a change to the way that the Treasury and the OBR assess the increases to tax receipts and the budgetary savings accruing from such investments. The return on investment for such policy interventions is now much better understood and quantified than it used to be, thanks to tools such as the Cost Benefit Analysis (CBA) model] developed by the Greater Manchester Combined Authority (GMCA), the Social Value Engine developed by Rose Regeneration and the various tools listed in Appendix Three of Public Health England's Inclusive and sustainable economies: leaving no-one behind. Of course, it shouldn’t be assumed that all such investment will inevitably provide the return that’s predicted – but neither should it be assumed that because there is some uncertainty over the level of returns, that the investment should be avoided. (One way to present this could be fan charts: the OBR already produces some fan charts for possible trajectories of fiscal measures, with a central forecast. There may be a case for greater use of these for assessing investment risks and potentials.)

And it shouldn’t be assumed that all such investment funded by borrowing will increase the supply of gilts without an accompanying increase in demand. Such investments could be packaged as social impact bonds (or similar) and may be attractive to buyers who wouldn’t otherwise invest in gilts.

Of course, some investments may take longer than a Spending Review period to produce a return to the Exchequer. In such cases, there may be an argument for calculating the Net Present Value (NPV) of such investments and treating this as an asset to be weighed against the cost of investment. This would be much more in keeping with the principle that Rachel Reeves proposed than the changes to the primary measure suggested in the IFS article. However, in practice, I would imagine there could be a lot of uncertainty in accurately estimating the NPV of some investments. And again, I would urge not fixating purely on a single measure of debt.

Unlocking local growth and transformation

Another aspect of revising the system of public finances is accurately reflecting the relationship between different parts of the public sector. In particular, as extensively covered in Building Freedom, the growing fiscal autonomy of local government.

Currently, Spending Reviews, Budgets and other fiscal documents, as presented to Parliament by the Government’s top financial minister, present figures for the whole of the public sector. In doing this, figures which include local government funding and expenditure are effectively presented as though they are the Government’s own funding and expenditure. This includes funding for both revenue and capital spend from sources other than central government – such as local tax revenues, loans from banks and bonds issued by the new UK Municipal Bonds Agency.

This is far from universal across the world – Building Freedom looks at the situation in Canada (particularly in the province of British Columbia) and in Denmark, Sweden and France, and finds very different presentations of public finances in these, often providing more separation in the data than in the UK.

The Chancellor recognised in her speech that investment in local growth will take different forms in different areas of the country, depending on the strengths of the local economy – she mentioned the automotive industry in the West Midlands, life sciences in the North West, clean technology in South Yorkshire and so on. Local authorities are ideally placed to identify the key strengths of their local economies and capitalise on them, working in partnership with other anchor institutions. By separating out local authority budgets from central government ones in fiscal documents and focusing Treasury attention on the central government figures, the new Government could unleash this potential for local growth.

For capital investment, this would automatically take place under the Prudential Regime, which ensures that councils plan and budget prudently for capital spend. However, there is already a flexibility to use capital receipts to fund the revenue costs of projects that deliver ongoing savings or improved efficiency. If local authorities were permitted also to invest funding from any source prudently in revenue projects, then this kind of transformational project would no longer be limited to just those with significant capital receipts.