UK budget deficit

Why we are where we are!

• The deficit has risen as a number of complex factors come together.
• There was a rapid increase in spending in the last few years of the labour government
• This followed many years of when Gordon Brown was the Chancellor of the Exchequer and he advocated fiscal prudence, being very careful with the balance of spending and taxation.
• Later on there was an acceleration in the growth of public spending
• One example would be state education
• Between 2005 and 2010 the employment in our schools rose by 16% at a time when the number of pupils in a state school were actually falling.
• So there has been a large increase in spending by the government which was then followed by the financial crisis and the largest recession since WW2.
• Recession reduces the tax take because people are unemployed and they are not paying income tax. Businesses are not making profits and therefore they are not paying as much corporation tax.
• Therefore the tax take falls at the same time as your spending rises because you are paying out more in benefits for example for people who are unemployed.
• Therefore recessionary periods tend towards a deficit. In the case of this recession of course it was exacerbated by the financial crisis, which involved the government paying out very large sums of money to support the banking system.
• The budget deficit in the financial year just ending will be c£150bn, more than 11% of GDP.
• Another way of looking at it is to say that over 20% of government spending this year will be paid for by borrowing. This is not sustainable.
• Alistair Darling, the former Chancellor of the Exchequer wanted to reduce the deficit more gradually than the current government. (Over a 3 to 4 year period)
• Nevertheless the coalition government wanted to cut public spending by more than £80bn over a 4 year period in addition to raising taxes.
• We can exaggerate the difference between the labour party and the coalition government
• Around two thirds of the cuts that the government is intending to introduce, the labour government was intending to bring in.
• So the coalition government have increased their cuts by about a third but they have also brought them in more rapidly.
• Cuts will begin to bite more seriously in the next financial year.
• The labour party would have made cuts rather later over the period 2014-2015.
• In June, the government announced their intention to make cuts of £80bn
• In October, the Comprehensive Spending review spelt out where these cuts were expected to fall.

• In 2006/07, 2007/08, we had a deficit of less than 3% of GDP.
• This increased dramatically in 2008/09 and then again in 2009/10 to approximately 11%
• The deficit of course is the gap in spending in a particular year whereas the debt is the accumulated borrowing over a period of time.
• For many years the level of debt has been around 40% of GDP
• In 2009/10 this increased dramatically to over 70% of GDP
• In context of the G7, we can see that back in 2007, we had the lowest ratio, around 40% of debt to GDP amongst these countries.
• However you can see by the projection that if nothing had been done by 2014 the debt would have been at nearly 100% of GDP.
• Considerably higher than some of the other countries.
• Japan has a colossal debt to GDP ratio.

Key points of Chancellor George Osborne’s October Spending Review

• Initially it was projected that these cuts would lead to around 490,000 public sector jobs to be lost over this period 2014-15
• This has been revised downward more recently since the comprehensive spending review
• The office for budget responsibility, this new body that the coalition government created to check on the figures has revised this figure downwards to only 330,000 job losses.
• The public sector currently accounts for over 5 million employees
• At a departmental level, the government departments are expecting an average 19% cut over the 4 year period.
• The intention being to eliminate structural deficit by 2015
• There will also be additional welfare budget cuts
• Retirement age is to rise from 65 to 66 by 2020
• That will save lots of money in terms of it is one year less pension money to pay out
• Schools budgets are protected
• Social Care budgets are protected
• NHS budget is protected
• Regulated Rail Fares are to rise above the rate of inflation
• The Bank levy (tax on banks) is to be made permanent

Is the Deficit really a problem?

• Who do we owe the national debt to?
• There seems to be an impression amongst the general public that national debt is owed to someone else
• In fact it is owed to ourselves in various forms.
• We are owed it as individuals by the taxpayer
• It is not something which is owed externally
• Some of our debt is held by overseas investors and governments but we are net creditors in international terms.
• National Debt can therefore be treated as being largely owed within the country
• And Government borrowing isn’t wrong in itself, especially if it is borrowing for investment e.g. a high speed railway through London. This will create jobs, increase revenue etc
• Even short term borrowing makes sense because when they issue treasury bills, they are taken up by the banking system, which then forms part of their liquidity.
• It enables the financial system to work more effectively
• If the Government didn’t borrow any money at all, then the financial system would have to come up with a new way of promoting short term liquidity
• Another aspect of this is that the UK Government is borrowing cheaply.
• Most of the UK debt is long term.
• The average maturity on government debt is 40 years
• It is not as if the bailiffs are going to turn up any day now.
• There is also the argument that the fiscal deficit should be countercyclical
• There are automatic stabilisers in the economy.
• That is to say that when we are in a recession we expect tax to fall and expect spending to rise and these offset the downturn in the private sector to a degree
• So fiscal deficit in a cyclical sense makes sense
• There is also the danger of a double dip recession if you cut too much too quickly
• These arguments are saying hold on a minute, why are we cutting back so dramatically
• Why are we cutting back on £80bn of public spending – do we really need to do this?

Yes but…

• On the other hand do fiscal deficits really boost demand in the economy?
• This is based on a Keynesian type analysis of the economy, the belief that Aggregate Demand is the driver of the economy and therefore we ought to do whatever we can to boost AD.
• There are strong views against this by many economists arguing that if we do in fact borrow money on a large scale and people are expected to pay taxes later on, they will save more, so it won’t really increase spending
• That’s one argument
• Secondly the deficit we have at the moment is not simply a cyclical deficit brought about by the recession.
• It is a structural deficit
• This means it is a deficit which will persist even when the economy is at somewhere near full employment.
• We expect the economy to have a deficit when the economy is in a recession but even if we were to recover and get back to high levels of employment and output and growth of 3-4%, this deficit will still persist as it is structural rather than cyclical.
• Therefore we have to do something about in the long term.
• Furthermore there is a lot of government debt and obligation which does not appear in these figures
• One of these is the growing burden of state pensions
• More and more pensioners, better and better pensions over time, it is a bigger and bigger burden.
• If we were to persist with the kind of deficit we have at the moment and we weren’t to do anything about state pensions, then the young generation would be paying very high taxes in the future.
• The burden of future taxation is a big issue
• Finally the confidence issue.
• If the financial markets lose confidence in the government they will make borrowing more costly for us by means of a rise in interest rates
• A rise in interest rates will deter investment and consumer spending and prolong any recessionary tendencies.
• So although the arguments for reducing the deficit may have been exaggerated we cannot ignore the deficit as it is clearly unsustainable.

• So what are we spending all this money on?
• Social Protection and benefits is the largest single category
• Health is another major area
• Education - 9m people in state schools in England alone.
• So the 3 large areas are Social protection, health and education.

• We can also look at where we get our tax from in terms of Government receipts
• The largest single group is income tax - £150bn
• National Insurance and VAT are also large
• Corporation tax is about £40bn
• At the moment, this is only paying for about 80% of the government’s expenditure.
• The other 20% is pad for by borrowing

• If we look at Capital Spending vs. Current Spending
• Capital Spending is more concerned with investment e.g. buildings, equipment etc
• Current Spending is more to do with salaries
• We can see that the cuts in capital spending are a lot higher than the cuts in current spending
• There is a 60% cut in capital spending in education
• This is partly as a result of the cut back in the school building programme which was announced in the June budget

Effects of Government Spending Cuts

• Direct fall in employment in public sector
• 330,000 projected by the office of budget responsibility
• Apart from that there is an indirect fall in the suppliers and contractors to the public sector, those companies who would have been building schools etc, now find that the demand has disappeared
• We have also seen cuts in benefits
• Individual households which depend on the benefits will have a fall in income.
• These effects will also have multiplier effects on demand
• If your company is not doing very well, you cannot spend on something else.
• If you as an individual receive fewer benefits, you have a lower income; you cannot spend your money on going out. You cannot buy as much food etc
• There is a multiplier effect on these people who would have supplied you these goods and services
• It is anticipated that as a result of the government spending cuts, reduced overall growth in the UK economy, compared with what would have been the case if the cuts had not taken place.
• This year the OECD has forecast that we will grow by 1.7%, which is well below the level we sustained for many years before the recession.
• However some opportunities may emerge
• Cutting back on the public sector may mean that there will be more opportunities for services to be contracted out to private suppliers rather than provided by people who are directly employed by the public sector

Regional Variations
• It is also very important to remember the regional variations in the effects of these cuts
• Government spending accounts for 65% of activity in Northern Ireland and 63% in Wales, 59% in the Northeast but only 37% in the southeast and only 32% in London.
• London has huge private sector, financial sector activities.
• London is therefore much less reliant on state spending than some parts of the country.
• The indication of this is that the cuts which are taking place will have a different impact on different parts of Wales, England, Scotland and Northern Ireland.

Alternatives?

• The labour party say we could go slower with the cuts
• We could spread them over a longer period
• The difficulty with this method is that it may undermine confidence and the credibility of the Government
• It means we are putting off difficult decisions which we will have to make anyway such as raising the pension age etc
• It is better to get these done now and then we can move on without having this hang over us.
• Some people are arguing that we are doing everything the wrong way round.
• Instead of cutting back on spending, we should increase taxes.
• However Tax is already high and the tax base is limited. 1% of all income tax payers pay more than 25% of all income tax.
• The top 1% of companies pay 81% of all corporation tax
• It is not easy to boost taxation.
• On an individual level there is a point where you cannot push people.
• Back in the 1970’s this idea of the Laffer Curve came about.
• The idea being that if you push up the tax rate, people will work less and therefore the tax take, the amount which is actually raised in tax, may not increase when you push up the tax rates
• This view has been expressed recently by the institute of fiscal studies for example, that the 50% top tax rate of income tax may not actually bring you any extra money.
• Therefore you have to ask whether putting up taxes would actually significantly increase the tax take
• In terms of tax avoidance, a situation where very large firms are not paying very much tax, we could increase the tax take by some degree, however there would be costs involved with this as you would need to employ more people in HMRC to pursue companies to make sure that they were paying all the tax that they should have been paying.
• It is difficult to increase tax take very much.
• The OECD suggests that the optimal rate of tax to cuts is 20% increase in tax to 80% in spending cuts.
• The coalition government have slightly more taxation (23:77)

• In terms of the UK Labour Market, the Unemployment Rate has not increased by as much as some pessimists suggested a year ago.
• The rate has steadied at just under 8% of the working population.
• The employment rate has fallen to about 70%
• This varies from group to group.
• For young people the unemployment rate is over 20%
• Although this figure is misleading as a large proportion of the 16-24 age group are in full time education. CIPD suggest a truer measure is about 13%
• The unemployment rate is actually not too bad given the situation that we find ourselves in.
• In most of the continental European countries the level of unemployment is significantly higher e.g. Spain and Italy

• Another worry is Inflation, which has been much higher than the target set by the Monetary Policy Committee
• There has been a lot of pressure on the MPC to raise interest rates in a bid to curb Inflation.
• The balance of opinion in the MPC is beginning to shift as Mervyn King, the governor of the bank of England expressing great concern about this ongoing high inflation.
• However if we raise interest rates, this could lead to further problems
• This means people pay more for borrowing and mortgages
• Spending power is reduced
• Investment may be discouraged
• This will also have the affect of raising the exchange rate
• When the interest rate in the UK rises, relative to that of other countries, it makes holding sterling more attractive and therefore demand for sterling increases and the exchange rate goes up.
• This could be problematic as it raises the cost of the goods that we export.

Prospects for the UK Economy and the Government’s Strategy – Slide 19

• Bear in mind, that we are a relatively small economy and we are influenced by other countries growth, our exchange rates in relation to other currencies and so forth.
• For example the earthquake in Japan will have an impact on the global economy. The implications at the moment are not entirely clear.
• The Japanese stock exchange has fallen dramatically because clearly Japan is in a very difficult situation. And we saw from the chart earlier that they already have a massive ratio of debt to GDP, far larger than the other OECD Countries. And now they will have to borrow huge amounts of money to finance reconstruction.
• How will the financial markets be affected?
• How will the cuts affect consumer demand?
• Will people spend or with all these cuts taking will they save more?
• We saw that unemployment was not too high given the circumstances. However what will this be like in a year’s time? This will depend largely on the flexibility of the labour markets.
• People may be prepared to take pay cuts and 0% increase in salaries
• What will the unions be doing?
• Unions have come out and said they will strike against plans to cut public sector pensions
• Will this happen and what will the affects be?
• Regulation and Red Tape – If we want the economy to recover then we have to make it easier for firms to do business, to take on new workers, to start new corporations, to build new factories etc
• Regulation could be a problem.
• David Cameron has said that he will cut back on red tape
• Since the Coalition Government have come into power, they have passed 218 new laws and they have only repealed 110, so we are still getting this growing regulation of business
• Another thing, which is being talked about is whether all these cuts can actually be delivered?
• For example, is it possible to get people on incapacity benefits, who have been unemployed for a very long period of time, off these benefits very quickly?
• They have introduced various tests for this but there is a huge backlog of appeals.
• It is very difficult to get this done
• Can you make people redundant?
• All sorts of procedures you have to go through even if you are in the public sector to get rid of people.
• How quickly can you do that? Can these cuts really be delivered?
• Political Power – There is a lot more legislation to get through parliament in connection with the cuts. For example the cuts in state pension will need to get through parliament.
• If the coalition sees falling figures in the opinion polls will they actually stick with it?
• And finally, Events – over a 4 year period, which is what we talk about with these cuts, anything can happen.
• We know from past experience we do not know what the world will be like in 3 or 4 years time!