By AINSLEY THOMSON and PAUL HANNON
LONDON—The International Monetary Fund urged the U.K. government to counter the effects of its austerity program by raising spending on infrastructure projects to avoid long-term damage to the nation’s growth prospects.
Launched in 2010, the austerity program is the government’s cornerstone policy, and Chancellor of the Exchequer George Osborne has indicated he won’t change course.
The IMF had been a backer of the plan, allowing Mr. Osborne to use the fund’s approval to validate his measures to improve the country’s public finances.
But the IMF now believes that without action to soften the impact of the program, businesses will be reluctant to invest, and that will hinder the U.K.’s ability to generate economic growth by becoming more competitive and raising exports.
“The key risk is that persistent slow growth could permanently damage medium-term growth prospects,” the IMF said. “After five years of relatively weak activity, additional measures are needed to raise long-term expectations of potential growth, while rebalancing necessitates a transformation to a high-investment and more export-oriented economy.”
The U.K. was one of the first major economies to embark on spending cuts and tax increases to tackle a budget deficit that swelled during the financial crisis. Its progress is closely monitored by other debt-laden Western countries.
Withdrawal of the IMF’s backing of the U.K. will add to the wider debate in the U.S. and across Europe over whether austerity has become a major drag on economies, and whether countries should be pursuing more growth-friendly plans.
The IMF said that with borrowing costs very low by historical standards, the U.K. government can afford to ease back on efforts to cut its budget deficit and provide “near-term support to the economy,” chiefly by bringing forward planned capital spending and offering guarantees to boost private investment.
“Our view of the fiscal situation is that the discretionary fiscal measures that are planned for this year will likely impart a drag on the economy and it would be desirable to try and offset that drag by bringing forward infrastructure spending and undertaking some tax measures,” David Lipton, the IMF’s first deputy managing director, said during a news conference in London.
Mr. Lipton wouldn’t say how much the government should borrow to invest in infrastructure, but there would be £10 billion ($15 billion) of austerity measures implemented this financial year that need to be offset. He said infrastructure spending would give the economy a “significant kick” and said projects such as building social housing and repairing schools and other public facilities could be started quickly.
Mr. Lipton said the risk of the government not acting was that the unemployment rate would remain high, while the output gap—the difference between what the economy produces and what it could produce if resources such as idling production lines and unemployed workers were in use—would not be reduced.
“People out of work become less employable, the absence of investment leaves you with a smaller stock of capital,” Mr. Lipton said. “So there is the peril that the economy will underperform for some time.”
Also at the news conference, Mr. Osborne said there were no easy answers to the problems that had built up in the U.K. over many years.
“It’s a hard road to recovery, but we are making progress,” he said. “Of course there is further to go—and we have to go on confronting the difficult choices to help our economy heal.”
The chancellor said he agreed with the IMF’s view to prioritize infrastructure investment “where we can.”
“That’s why we are investing more in capital than my predecessor planned; That’s why I’ve added in the last two years to those plans,” Mr. Osborne said. “That will be done within the credible fiscal plan we’ve set out.”
The IMF also said the government should consider a further cut to the tax rate on company profits to boost investment, which it said was at its lowest level relative to economic output since the end of World War II. To balance that cut, it said, the government should consider extending its sales tax to a broader range of goods and services and increase taxes on property.
The IMF urged the Bank of England to keep its “accommodative stance” for an extended period and said the central bank should make that intention clear to households and businesses. “The BOE could provide assurance to households and investors that policy rates will be kept low until the recovery reaches full momentum,” the fund said.
That is a show of support for incoming BOE Governor Mark Carney, who will take over from Mervyn King in July and who has made it clear he favors using “forward guidance” as a tool to stimulate economic growth.
Such guidance has taken different forms. In the U.S., the Federal Reserve has promised not to touch short-term rates and to keep buying securities until unemployment falls to 6.5%, barring any meaningful change in prospects for inflation.
However, many of Mr. Carney’s future colleagues on the bank’s Monetary Policy Committee are openly skeptical about the use of guidance.
The IMF said the MPC should consider increasing its bond purchases using freshly created money, a stimulus program known as quantitative easing.
—Jason Douglas and Alex Brittain contributed to this article.
Write to Ainsley Thomson at email@example.com and Paul Hannon at firstname.lastname@example.org