Does public investment have to pay for itself?

A key distinction between Labour’s new fiscal rule and Osborne’s fiscal charter is that the former allows borrowing for investment. When supporters of the fiscal charter treat borrowing as if it was inherently sinful (‘Labour will borrow forever’) it is natural to remind them that firms often borrow to invest and grow, and consumers invariably borrow if they buy a house. We also note that public investment can enhance economic growth. But this can lead to a confusionabout whether such investment has to ‘pay for itself’.

When a firm borrows to invest, it hopes to make enough profits to pay back the borrowing. There may be forms of public investment which could raise future GDP (and therefore income and spending) such that eventually taxes rise by enough to pay at least the interest on the borrowing that made the investment possible, or even start paying back the borrowing itself. But there are two other important reasons why it makes sense to borrow to invest.

The first involves intergenerational equity. Suppose we have a public investment project which significantly enhances the quality of life, but there is no pecuniary benefit: GDP does not rise. So taxes will have to rise at some point to pay for that borrowing. But who should pay those taxes? When we are talking about investments that are long-lived, the obvious answer is those that benefit from the investment, which means future generations as well as the current generation. That can happen if investment is paid for by borrowing rather than raising current taxes.

This helps answer a point that is often raised, which is what should count as public investment and what should not. With this reasoning it makes sense to borrow whenever the social benefits of public spending are long lasting. When the benefits are short lived, spending should be paid for by higher taxes. So the relevant metric for what should count as investment in this context is who benefits most. While paying doctors or teachers more may have some knock on benefits for the future, the main beneficiary will be today’s doctors or teachers. The benefits of new schools and hospitals are longer lasting. 

The second reason for using borrowing to pay for investment is if the increase in investment is a one-off. As taxes are distortionary at the margin, it makes sense to smooth those taxes over time. Once again, that can be achieved using borrowing.  

If a lot of public investment does not pay for itself, wouldn’t borrowing only to invest mean that debt just went on increasing and increasing? What matters here is the debt to GDP ratio. If you want to keep that ratio constant, and you always run a zero current balance, then that tells you how much investment you can do. The numbers are fairly simple to work out. If the economy grows in nominal terms by 4.5% on average, and debt is 80% of GDP, net investment could be around 3.5% of GDP to keep the debt to GDP ratio constant. Osborne plans net investment over this parliament averaging 1.6% of GDP.

This leads to one final, important point. You cannot have separate goals for all three of debt to GDP, the current balance, and public investment. In Labour’s new rule, the commitment to reduce borrowing as a share of trend GDP over the lifetime of a parliament, coupled with the zero current balance target, puts an upper limit on the amount of investment the government could do. Whether that is a sensible upper limit in economic or political terms, and what you do if it is not, I will leave as an exercise for the reader.