Fiscal Policy - Taxation and Public Expenditure

This chapter seeks to build on your study of fiscal policy at AS level. Government Spending Government spending can be broken down into three main categories: o o o General government expenditure - capital and current spending of central government including debt interest payments to holders of government debt. General government final consumption - spending on current goods and services excluding transfer payments the main item of spending is on pay for public sector workers. Transfer payments from taxpayers to benefit claimants through the social security system.

Government Spending Objectives The Treasury has outlined the main goals of fiscal policy to be the following: o o o Equity concerns: To ensure that government spending and taxation impact fairly within and across generations fiscal policy should be equitable to current and future generations. Funding government spending: To meet the governments spending and tax priorities without a damaging rise in the burden of government debt. The benefit-pay-principle: This principle seeks to ensure that those who benefit from public services such as state education and the NHS also meet the costs of the services they consume. Macroeconomic stability: Fiscal policy in the UK is designed to support monetary policy in contributing to an environment of sustainable growth and stable inflation.

The level of spending by the UK government has soared in recent years and has been criticised by those who claim that public sector spending is open to a high level of waste and lack of productive efficiency. Successive governments have striven to improve the efficiency with which public services are provided. This has included the use of contracting-out and competitive tendering where private sector businesses compete with the public sector for the contracts to provide services such as NHS catering, laundry and cleaning together with maintenance of the road network and aspects of the prison service. The government has also introduced value for money audits for each major government spending department together with a huge and growing number of performance targets. As we see below, the share of national income taken up by government spending has risen from 41% when Labour came into office in 1997 to over 50% now. Ultimately a state that spends such a high percentage of GDP needs to raise an equivalent amount in tax revenues to pay for the spending otherwise public sector borrowing and the national debt rises to unsustainable levels.

UK Government Spending and Taxation

Measured as a percentage of national income (2010-11 is a forecast from the OECD)

55.0

55.0

52.5

52.5

50.0

50.0

Per cent of GDP

47.5 Total Government Spending 45.0

47.5

45.0

42.5 Total Tax Revenue 40.0

42.5

40.0

37.5

37.5

35.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

35.0

Source: OECD World Economic Outlook

When government spending > total tax revenues as a share of GDP then there is a budget deficit When government spending < total tax revenues then there is a budget surplus.

The OECD is forecasting that in 2010 the budget deficit will be in excess of 12% of national income, one of the biggest fiscal deficits that the British economy has ever seen. Taxation The current government's objectives for the British tax system are broadly as follows: 1. The burden of tax: To keep the tax burden as low as possible (measured as the % of GDP) 2. To improve incentives 3. Equitable taxes: To ensure taxes are applied equally and fairly to everyone. Equality is not always the same as fairness see the notes below on the canons of taxation 4. Correct for market failure: Using taxes to make markets work better including externalities. Principles of a Good Tax System Adam Smith developed one set of principles known as the canons of taxation in his famous work on the Wealth of Nations published in the late 18th century. Efficiency - an efficient tax system raises sufficient revenue to pay for government spending, without reducing work-incentives for individuals and investment incentives for companies. Equity taxes should be fair and based on people's ability to pay. The benefit principle of taxation this principle is that taxes paid by people have a link with the benefit that the person paying the tax actually receives from government spending. The benefit principle is mainly concerned with allocative efficiency rather than equity.

Transparency and certainty - taxpayers should understand how the system works and should be able to plan their tax affairs with a reasonably degree of certainty. Taxes should also be difficult to evade and should not be too difficult or expensive to collect.

Income Tax, VAT & Corporation Tax

Annual tax revenues, measured at current Prices, billion

175

175

150

150

125

125

(billions)

75

Income tax

75

50
VAT

50

25
Corporation tax

25

0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: HM Treasury Public Finance Databank

Progressive Taxation
NUMBER OF TAXPAYERS (THOUSANDS) 1,440 6,390 4,930 6,910 2,010 470 11 31,000 AVERAGE RATE OF TAX (PERCENTAGES) 1.9 8.4 11.7 14.0 23.3 30.1 35.9 17.9

INCOME TAX PAYABLE BY INCOME 6,0357,499 10,00014,999 15,00019,999 20,00029,999 50,00099,999 100,000199,999 1,000,000 and over All incomes

In a progressive tax system the average rate of tax rises with income for example, income tax is progressive in its effects on disposable income. The table above gives a flavour of how the tax burden rises with taxable income. For someone with an annual taxable income of 13,000, the tax rate is just under 12% whereas for some earning well over 100,000 the percentage taken in tax rises above 30%. In the 2009 Budget, Chancellor Alastair Darling raised the rate of income tax on those earning over 150,000 to 50% from April 2010. In addition the government has announced the phasing out of tax-free personal allowances for those earning six figure sums. There will be no personal allowance at all, once someones income reaches about 113,000

billions

100

100

These decisions make the tax system a little more progressive although there are strong arguments on both sides on whether or not the decision is a sound one. Which tax system to use? Direct versus Indirect Taxation o o Direct taxes are paid directly to the Exchequer by the individual taxpayer usually through pay as you earn. Tax liability cannot be passed onto someone else Indirect taxes include VAT and a range of excise duties on oil, tobacco, alcohol. The supplier can pass on the burden of an indirect tax to the final consumer depending on the price elasticity of demand and supply for the product. Current duty levels include: Beer 36p per pint Wine 157p per bottle Cigarettes 345p per packet of 20 Duty on diesel and petrol 54p per litre Landfill tax 40 per tonne Value added tax (standard rate) 15% Council Tax Rate (Band D) 1414 per year ARGUMENTS AGAINST USING INDIRECT TAXATION 1. Many indirect taxes make the distribution of income more unequal because indirect taxes are more regressive than direct taxes 2. Higher indirect taxes can cause cost-push inflation which can lead to a rise in inflation expectations

ARGUMENTS FOR USING INDIRECT TAXATION 1. Changes in indirect taxes can change the pattern of demand by varying relative prices and thereby affecting demand (e.g. an increase in the real duty on petrol) 2. They are an instrument in correcting for externalities indirect taxes can be used as a means of making the polluter pay and internalizing the external costs of production and consumption 3. Indirect taxes are less likely to distort the choices that people have to between work and leisure and therefore have less of a negative effect on work incentives. 4. Indirect taxes can be changed more easily than direct taxes this gives policy-makers more flexibility. Direct taxes can only be changed once a year at Budget time 5. Indirect taxes are less easy to avoid, often people are unaware of how much in duty and other spending taxes they are paying 6. Indirect taxes provide an incentive to save savings help to provide finance for capital investment 7. Indirect taxes leave people free to make a choice whereas direct taxes leave people with less of their gross income in their pockets

3. If indirect taxes are too high this creates an incentive to avoid taxes through boot-legging e.g. the booze cruises to France where duty on alcohol and cigarettes is much lower. 4. Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a recession causing a fall in consumer spending 5. There is a potential loss of welfare from duties e.g. loss of producer & consumer surplus 6. Higher indirect taxes affect households on lower incomes who are least able to save 8. Many people are unaware of how much they are paying in indirect taxes they may be taxed by stealth this goes against one of the basic principles of a tax system that taxes should be transparent

The Tax Base The tax base refers to the number of tax-paying agents in the economy and the amount of income, wealth and spending on which taxes are applied. When an economy is expanding, so does the tax base. There are more people in work, businesses are growing and making more profits. And both prices and incomes tend to rise, all of which leads to a rise in tax revenues flowing into the Treasury. The reverse happens during a recession. Indeed one of the features of the 2009 recession has been the slump in tax income for the UK government a feature of the downturn that has contributed hugely to the rising budget deficit. Fiscal Drag Fiscal drag occurs when tax allowances do not rise in line with prices and incomes. The result is that people and businesses end up paying a larger percentage of their incomes in tax. Tax competition Tax competition describes a process where a national government decides to use reforms to the tax system as a deliberate supply-side strategy aimed at attracting new capital investment and jobs into their economy. The issue has become important in the European Union because some countries including France and Germany complain that poorer countries are using tax competition as an incentive to attract inward investment, yet they are also net recipients of EU structural funds. If these countries can afford to lower business taxes, can they also afford not to do with the extra EU funding that helps to finance, for example, infrastructural spending required sustaining fast rates of economic growth? Flat Rate Taxes A flat tax means that everyone is taxed at just one rate. I.e. everyone pays the same percentage tax on any income earned above the tax threshold. Examples of countries that have moved towards flat rate tax systems include Estonia, Latvia, Poland, Lithuania, Russia, Slovakia and Hungary. Supplyside economists are often fans of flat rate taxes because they think that they will 1. Help reduce red tape and reduce the resources wasted on tax forms, chasing up non-payers and enforcing tax laws. This would reduce the money spent on administering the tax system. 2. Boost incentives for people to work, to save (e.g. for retirement) and for companies to use profits to invest - both of which could increase the countrys potential growth rate. 3. Generate increased tax revenue based on the idea of the Laffer Curve 4. A flat tax may make an economy more attractive to foreign investment. Arguments against 1. Flat rate taxes are no longer progressive and so the distribution of income and wealth will be more unequal certainly in the short and medium term. 2. Flat taxes can form part of a race to the bottom with governments competing with each other to offer the lowest rates of tax to entice inward investment and skilled workers. 3. If tax rates are cut, some people may choose to work less because they can earn the same income from working fewer hours. 4. There is no guarantee that businesses will engage in more investment and R&D if company taxes are lower they may simply offer more in the way of dividends to their shareholders!

Microeconomic effects of tax changes 1. Taxation and work incentives: Can changes in income taxes affect the incentive to work? Consider the impact of an increase in the basic rate of income tax. This has the effect of reducing the post-tax income of those in work because for each hour of work taken the total net income is now lower. This might encourage the individual to work more hours to maintain his/her target income. Conversely, the effect might be to encourage less work since the return from each hour worked is less. Changes to the tax and benefit system also seek to reduce the risk of the poverty trap where households on low incomes see little financial benefit from supplying extra hours of their labour. If tax and benefit reforms can improve incentives and lead to an increase in the labour supply, this will help to reduce the natural rate of unemployment and increase the economys non-inflationary growth rate. 2. Taxation and the Pattern of Demand Changes to indirect taxes in particular can have an effect on the pattern of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect among consumers and thereby reduce the demand for what are perceived as demerit goods. The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But there might also be a justification based on achieving a more equitable allocation of resources e.g. providing basic state health care free at the point of use. 3. Taxation and labour productivity Some economists argue that taxes can have a significant effect on the intensity with which people work and productivity. But there is little empirical evidence to support this view. Many factors contribute to improving productivity tax changes can play a role - but isolating the impact of tax cuts on productivity is extremely difficult. The Laffer Curve Created by the US supply-side economist Arthur Laffer, this curve tries to shows the relationship between tax rates and tax revenue collected by governments. It argues that as tax rates rise, total tax revenues rise at first but perhaps at a diminishing rate. There may be an overall tax burden (e.g. expressed as a percentage of GDP or as a percentage of income) which yields the highest tax revenues and that beyond this, further hikes in taxation serve only to reduce the money flowing in. The Laffer curve has been used as a justification for cutting taxes on income and wealth - the argument being that improved incentives to work and create wealth will broaden the base of tax-paying businesses and individuals and also reduce the incentive to avoid and evade paying tax. Lower taxes might increase tax revenues. For this to be the case the labour supply must respond elastically to the change in post-tax wages or salaries and/or we need information on the lengths to which the rich will go to avoid paying taxes. A Keynesian interpretation might be that lower direct taxes could stimulate higher spending within the circular flow which itself boosts demand, output, profits and employment, all of which can drive tax revenues higher. The Laffer Curve came back into the news in Spring 2009 when the Labour government announced a rise in the top rate of income tax designed to raise more than 5bn per year and help plug some of the holes in the government's finances. Will a rise in higher income tax rates yield the extra revenue Laffer curve supporters argue that it might fail to do this, perhaps even cause revenues to fall. The richest 1% of UK taxpayers paid 23% of all income tax collected in 2008-09. And the richest 5% pay 42% of the tax. In 1999-00 these ratios were 21.3% and 39.6% respectively. The independent Institute for Fiscal Studies (IFS) has calculated that the peak yielding tax rate for UK income tax is

about 42.5% and that, on this model, the 55% tax due to start in 2010 would actually lose 800m to the Exchequer.

Case Study: Does the UK tax system need reform?

George Osborne on Emergency Budget Day in 2010 The current state of the public finances in Britain with a predicted fiscal deficit of over 12% of GDP for 2009-10 has led many to wonder how this deficit will be halved, as the present government have pledged, in the four years from 2011. The governments commitment will mean some difficult decisions on public expenditure and taxation particularly as half of the reported deficit is structural, meaning that it will not disappear when the economy recovers and tax revenues start to rise again. The cyclical part of the deficit is of less concern, but the structural deficit needs tackling either by cuts in government expenditure and/or tax increases. Deficits of the size run by the UK become increasingly difficult to finance through the sale of government debt (gilt-edged securities). On the tax issue the government has a problem because tax revenues are barely over 35% of GDP as a result of the erosion of the tax base due to the recession. Simply putting up taxes may not be the answer as the new 50% higher tax rate might demonstrate. In addition, personal and corporate tax regulations in the UK have become hugely complex in recent years. The abolition of the 10% income tax rate has arguably affected incentives to work and the planned 50% rate may do the same at the other end of the income scale. There is a view that in order to boost economic growth and promote an enterprise culture the government need to switch the burden of tax away from income, wealth and savings and towards expenditure and the environment. Taxes on environmental degradation will raise revenue, reduce external costs and internalise negative externalities. Direct taxes on income and wealth are prone to avoidance and evasion and can affect incentives whereas indirect taxes on spending are much harder to evade. Hence maybe the UK government needs to think radically and by reforming the tax system try to achieve a remarkable double of increasing tax revenue and stimulating enterprise- thereby boosting the supplyside of the economy. The government could radically reform the tax system by using a 20% rate as the basis of all major taxes similar in principle to the flat tax system used by some economies in Eastern Europe. If VAT were raised to 20% and its scope extended to all goods and services (including food) revenue would most probably rise significantly although it would be regressive and lead to a bout of inflation. A Corporation Tax rate of 20% for all companies (its 21% for small firms and 28% for large firms at present) would be popular and may attract foreign inward investment. It may even boost tax revenue as Ireland found a few years ago when it reduced its company tax rate to 12.5%. It has been reported recently that there are a few large firms considering moving their tax domicile from the UK due to the high corporate tax rate here and the over complex tax regulations. The rate for Capital Gains Tax is at present is 18% - why not raise it to 20%? Similarly Inheritance Tax, a very unpopular tax, has a 40% rate. If it could be reduced to 20% would revenue from it fall or would it rise as avoidance falls? Income Tax could continue to use 20% as the present basic rate with the 40% rate being maintained to keep it progressive. However, a return of the 10% tax rate could reduce incidence of the poverty

and unemployment traps among the low paid. The forthcoming planned 50% tax rate could be cancelled, as it is unlikely to raise much revenue and have a negative effect on incentives. Clearly reform of this kind could be seen as far too risky when the public finances are so weak and there would always be doubt as to whether revenue would increase or not. Revenue effects would depend on where the levels of tax free allowances were set for the income and capital taxes. However, the UK tax system is a cumbersome mess at the moment and now may be the time to be radical revenue needs to rise while enterprise and incentives. Sadly no politician would have the courage to be so bold. Source: Ruth Tarrant, EconoMax, Spring 2010

Fiscal Policy and the Economic Cycle The credit crunch and recession has brought the use of fiscal policy as a demand-side instrument firmly into prominence. Many countries have chosen to introduce a fiscal stimulus in a bid to boost confidence and demand and prevent a deflationary slump. But how effective is fiscal policy in the aftermath of a huge global demand shock? What are some of the medium term consequences of a big rise in government borrowing? Fiscal policy is the Governments main demand-management tool. Government spending, direct and indirect taxation and the budget balance can be used counter-cyclically to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock. 1. Discretionary fiscal changes are deliberate changes in taxation and govt spending for example a decision by the government to increase total capital spending on road building. 2. Automatic fiscal changes (also known as automatic stabilisers) are changes in tax revenues and state spending arising automatically as the economy moves through the trade cycle. Automatic stabilisers and the business cycle Automatic stabilizers refer to how fiscal policy instruments will influence the rate of GDP growth and help counter swings in the business cycle. During phases of high GDP growth, automatic stabilizers will help to reduce the growth rate and avoid the risks of an unsustainable boom and accelerating inflation. With higher growth, the government will receive more tax revenues and there will be a fall in unemployment so the government will spend less on unemployment and other welfare benefits. Conversely in a recession, GDP growth becomes negative but because of lower incomes, people pay less tax, and government spending on unemployment benefits will increase. The result is an automatic increase in government borrowing with the state sector injecting extra demand into the circular flow.

Recent evidence from the OECD suggests that a government allowing the fiscal automatic stabilizers to work might help to reduce the volatility of the economic cycle by up to 20 per cent. The strength of the automatic stabilizers is linked to the size of the government sector (e.g. government spending as a % of GDP), the progressivity of the tax system and how many welfare benefits are income-related. In short automatic stabilizers help to provide a cushion of demand in an economy and support output during a recession. Measuring the fiscal stance 1) A neutral fiscal stance might be shown if the government runs with a balanced budget. 2) A reflationary fiscal stance happens when the government is running a budget deficit.

3) A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T). The Keynesian school argues that fiscal policy can have powerful effects on AD, output and employment when the economy is operating below full capacity national output. Keynesians believe that there is a justified role for the government to make active use of fiscal policy measures to manage or fine-tune the level of aggregate demand particularly when the use of conventional monetary policy is proving ineffective. Monetarist economists believe that government spending and tax changes can only have a temporary effect on AD, output and jobs and that monetary policy is a more effective instrument for controlling AD and inflationary pressure.

The Fiscal Multiplier Economic history teaches us that a combination of tax cuts, running large fiscal deficits, substantial cuts in interests rates and more quantitative easing is likely, with a certain time lag, to have a substantial impact on demand in the economy and it may well be that the worst of the recession may well be behind us. Source: Professor David Miles, MPC member, April 2009 The fiscal multiplier measures the final change in national income that results from a deliberate change in either government spending and/or taxation. Several factors affect the likely size of the fiscal multiplier effect. Design: i.e. the important choice between tax cuts or higher government spending. Recent evidence from the OECD is that multiplier effects of direct increases in spending are higher than for tax cuts or increased transfer payments. Who gains from the stimulus? If tax reductions are targeted on the low paid, the chances are greater that they will spend it and spend it on British produced goods and services. But how soon will they get any benefit from reductions that they notice?

Financial Stress: At present, fiscal policy is operating in highly unusual and uncertain times. Uncertainty about job prospects, future income and inflation levels might make people save their tax cuts. On the other hand if consumers are finding it hard to get fresh lines of credit, they may decide to consume a high percentage of any boost to their disposable incomes. Temporary or permanent fiscal boost: Expectations of the future drive behaviour today ... most of us now expect taxes to have to rise in the coming years. Will this prompt a higher level of household saving and a paring back of spending and private sector borrowing? Monetary policy response: In the jargon, does monetary policy accommodate the fiscal stimulus (i.e. there are no offsetting rises in interest rates)? Consider a situation in 2010-2011 when the Bank of England holds policy interest rates close to 1% even if inflationary pressures are rising - this will drive down real interest rates and perhaps boost demand still further. But the central bank has an inflation target to consider and the Bank may start to raise interest rates and limit the impact of the fiscal boost. The availability of credit: If fiscal policy works in injecting fresh demand into the economy, we still need the banking system to be able to offer sufficient credit to businesses who may

need to borrow to fund a rise in production (perhaps for export) and also investment in fixed capital and extra stocks. Openness of the economy: The more open an economy is (i.e. the higher is the ratio of imports and exports to GDP) the greater the extent to which higher government spending or tax cuts will feed their way into rising demand for imported goods and services, lowering the impact on domestic GDP. Fiscal and monetary policy decisions in other countries: Modern economics are deeply inter-connected with each other. The UK government has decided to run a huge budget deficit - so what happens to government borrowing and interest rates in the EU, the USA and in many emerging market countries will have an important bearing on prospects for a broadly based recovery in global trade and output which then affects the UK economy.

Problems with Fiscal Policy as an Instrument of Demand Management In theory a positive or negative output gap can be overcome by the fine-tuning of fiscal policy. However, in reality the situation is complex. Different types of lag o o o Recognition lags: Inevitably, it takes time to for policy-makers to recognise a need for some active discretionary changes in spending or taxation. Imperfect information: The data that comes out on the economy is often delayed and subject to revisions. Response lags: It then takes time to implement an appropriate policy response. Tax cuts can feed through quite quickly but new capital expenditure is difficult to start; roads have to be planned, hospitals and schools designed Impact on consumer and business behaviour: It then takes time for the change in fiscal policy to work, as the multiplier process is not instantaneous.

Fiscal Crowding-Out The crowding-out hypothesis is an idea that became popular in the 1970s and 1980s when free market economists argued against the rising share of national income being taken by the public sector. The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector. For example, if the government chooses to run a bigger budget deficit, the government will have to sell debt to the private sector and getting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may crowd out private investment and consumption, offsetting the fiscal stimulus.

Interest Rates on 10-year UK Government Bonds

per cent
6.00
6.00

5.00
Quantitative easing programme started here

5.00

4.00
Percent

4.00

3.00

3.00

2.00

2.00

1.00

1.00

0.00 Jan

0.00

Mar

May

Jul 08

Sep

Nov

Jan

Mar

May

Jul 09

Sep

Nov

Jan

Mar

May 10

Jul

Sep

Source: Reuters EcoWin

Despite the growing budget deficit, UK bond yields on longer-dated government debt have remained low mainly due to the financial markets appetite for relatively low-risk Treasury Bonds of different duration. The Keynesian response to the crowding-out hypothesis is that the probability of 100% crowdingout is remote, especially if the economy is operating well below its capacity and if there is a plentiful supply of savings available that the government can tap into when it needs to borrow money. There is no automatic relationship between the level of government borrowing and the level of short term and long term interest rates. One interesting aspect of the UK economy is that UK government debt is long-term with an average maturity of 14 years this means that Britain is less exposed to problems of having to find money to repay lots of short term public sector debt. Crowding-In Some Keynesian economists argue that in an economic depression, fiscal deficits crowd-in rather than crowd-out private sector investment. In the aftermath of an economic shock, many countries operate with spare capacity that puts big downward pressure on business profits and jobs. Welltargeted timely and temporary increases in government spending can absorb the under-utilised capacity and provide a strong multiplier effect which then generates extra tax revenue. In 2009 we saw a spectacular fall in private sector borrowing government deficits provide a counter-weight to this. And the fact that real interest rates on ten-year government bonds remain at historically low levels suggests that there isnt an immediate funding crisis for western Governments who have chosen to use a fiscal stimulus as a counter-cyclical policy. Much of the funding for the borrowing at least in the short term will come from the rising savings of the private sector of rich advanced nations. The Rational Expectations View According to a school of economic thought that believes in rational expectations, when the government sells debt to fund a tax cut or an increase in expenditure, a rational individual will realise that at some future date he will face higher tax liabilities to pay for the interest repayments. Thus, he

should increase his savings as there has been no increase in his permanent income. The implications are clear. Any change in fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these circumstances may become ineffective. Government borrowing
Budget Deficits and Budget Surpluses in 2010 % of GDP Country USA Germany Italy France Spain UK Japan Deficit -9.5 -5.5 -5.5 -9 -10.3 -11.1 -9 Country Norway Saudi Arabia South Korea Singapore UAE Surplus 10 7.3 0.3 0.4 13.3

UK Government Borrowing and Debt

Budget balance and gross government debt as a % of GDP, 2011 is a forecast

90 80
% of GDP

90 80 70 Gross Government Debt (% of GDP) 60 50 40 30 5.0 Annual government budget balance Budget surplus 2.5 0.0 -2.5 -5.0 Budget deficit -7.5 -10.0 -12.5

70 60 50 40 30 5.0 2.5 0.0

% of GDP

-2.5 -5.0 -7.5 -10.0 -12.5 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: OECD World Economic Outlook

When the government is running a budget deficit, the state has to borrow through the issue of debt such as Treasury Bills and long-term Bonds. The issue of debt is done by the central bank and involves selling debt to the bond and bill markets. Does a budget deficit matter? A persistently large budget deficit can be a problem. Three of the reasons for this are as follows:

1. Financing a deficit: A budget deficit has to be financed through the issue of debt. In a world where financial capital flows freely between countries, it can be fairly easy to finance a deficit. But if the budget deficit rises to a high level, in the medium term the government may have to offer higher interest rates to attract sufficient buyers of debt. This raises the possibility of the government falling into a debt trap where it must borrow more simply to repay the interest on accumulated borrowing. 2. A government debt mountain? By the summer of 2009 UK government debt was surging above 800bn and is set to rise much higher in the next couple of years. There is an opportunity cost involved here because interest payments on bonds might be used in more productive ways, for example on health services or extra investment in education. 100 basis points equates to 1 per cent. Every 5 basis points (0.05%) saved on 220bn of new debt pays one years salary for 46,000 teachers. Higher public sector debt also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy. 3. Crowding-out - the need for higher interest rates and higher taxes. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then a process of fiscal crowding-out is said to be occurring. There must be a limit to which taxpayers are prepared to pay for government spending. The Institute of Fiscal Studies has estimated that that to reduce the UK budget deficit over the next five years will require every person in the UK to pay over 1250 of extra taxes each year. 4. Risk of capital flight: Some economists believe that very high levels of state borrowing and debt risk causing a run on the pound. This is because the government may find it difficult to find sufficient buyers of its debt and the credit-rating agencies may decide to reduce the rating on UK sovereign debt. If the risks of holding UK government debt go up, some foreign investors may choose to take their money out of the UK driving sterling lower in the currency markets. Potential benefits of a budget deficit 1. Government borrowing can benefit growth: A budget deficit can have positive macroeconomic effects if it is used to finance capital spending that leads to an increase in the stock of national assets. For example, spending on transport infrastructure improves the supply-side capacity of the economy. And increased investment in health and education can boost productivity and employment. 2. The budget deficit as a tool of demand management: Keynesian economists support the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending. If crowding out is not a major problem - fiscal policy can play an important counter-cyclical role leaning against the wind of the economic cycle Case Study: Fiscal Retrenchment for the UK Economy Fiscal retrenchment means that a government has to introduce deflationary fiscal measures designed to reduce the amount of borrowing and debt that has been run up during the downturn and economic/financial crisis. Ultimately fiscal retrenchment can be achieved in one of two ways *1 Raising indirect and direct taxation *2 Making cuts in the real level of government spending Both are painful - tax hikes might choke off a tentative recovery in 2010 and 2011 and reducing government spending must hit the availability of public services. The automatic versus discretionary fiscal policy choice

Much of the debate during the recent general election campaign focused on an important economic decision namely whether to follow an automatic or discretionary fiscal policy. Simply put, automatic fiscal policy is concerned with the changes in tax revenue and government spending that occur naturally over the course of the economic cycle; discretionary policy, however, concerns active manipulation of policy to change the amount earned in revenue and the amount spent. The former Chancellor Alastair Darling has emphasised the importance of allowing the economy to grow since this would automatically reduce the size of his budget deficit. In other words, he displayed greater confidence than the new Treasury team in the coalition government in the ability of automatic stabilisers to help restore a budget balance. When the economy grows, national income rises both because people already in work receive higher wages and because some previously unemployed people find work. This means that the government earns more in revenue from income tax and also in VAT receipts as people spend their higher income. Profits will tend to rise and so more is earned from corporation tax. At the same time, the government needs to spend less on unemployment benefits. So, tax revenue rises and government spending falls, automatically. With a few tweaks here and there, Alistair Darling reckoned that this would essentially be enough to reduce the size of the budget deficit. The new Business Secretary Vince Cable of the Liberal Democrats advocated during the election for significant cuts in government spending; essentially, a more discretionary approach. His range of options included severe limitations on public sector pay rises, scrapping defence projects such as the nuclear Trident submarines and banishing expensive projects such as the ID cards scheme. At the same time, he would reduce tax payments by lower income earners and substantially increase taxes on high earners. Overall, tax revenue would likely rise. This combination of lower government spending and higher tax revenue would, argued Cable, cut the budget deficit much more quickly than Labours suggested approach. Both approaches should allow the budget deficit to be reduced; it is likely that the more discretionary approach will reduce the deficit more quickly. Whether this is important or not depends on the ability of the UK government to raise funds to finance that deficit whilst it continues. Or the AAA-rating of UK debt is downgraded as a result of the poor state of the UKs finances. The automatic approach is entirely dependent on the UK achieving economic growth, whereas the discretionary approach is more likely to reduce the UKs growth potential, at least in the shorter-term. In practice, a combination of the two would probably be preferable. Source: EconoMax, Ruth Tarrant, spring 2010 Blanchflower critical of the governments fiscal plans Economist David Blanchflower has criticised George Osbornes contractionary fiscal policy at a time when economic growth in the UK is still anaemic, emphasising the collapse of multiplier effects from government spending, but also the negative impact on employment, both in the public and private sector, at a time when the private sector is still recovering slowly from the recession. Whilst cutting spending and raising taxation in a recession is clearly against the Keynesian ethos, Blanchflower accuses the Conservatives of also only following ideology rather than common sense, at a time when the government is one of the few entities to still able to spend right now. He says this, and while there are reasons why the fiscal outlook for the UK is different to Greeces. Although government debt is high (both in total and as a share of GDP), the yield on government bonds has been falling (making it cheaper to borrow money) and there is little sign that the financial markets have reached a tolerance threshold in terms of how much new government debt they are prepared to buy. Source: Tutor2u economics blog, July 2010

The Emergency Budget in the UK - July 2010 The new coalition government introduced an emergency budget in July 2010 designed to achieve a quicker than forecast reduction in the size of the UK's budget deficit. The Chancellors rule of thumb is that deficit reduction will need to be achieved based on the 80:20 rule, with 80 percent achieved through state spending cuts and 20 percent from tax rises. The main elements of the budget were as follows: 1/ VAT up from 17.5% to 20% from Jan 2011 - from which the Chancellor hopes to raise about 12 billion annually. 2/ Capital Gains Tax to rise from 18% to 28% from 23 June 2010 - this was not as great an increase as was anticipated by many speculators before the Budget. The rate for smaller businesses is less. 3/ Corporation tax -The UKs tax competitiveness for companies will improve with the phased reduction in the main rate of corporation tax from 28 percent to 24 percent by one percent for each of the next four years. Small companies will also benefit from a reduction in their rate to 20 percent from next April. 4/ Tax credits - the Chancellor announced a number of reductions to tax credits and welfare benefits. From April 2011, tax credit eligibility will be reduced for families with household income above 40,000. The Government will make further changes in 2012-2013 with the aim of focusing tax credits on lower income families. In addition, child benefit will be frozen for three years from April 2011. The new Chancellor George Osborne believes he will be able to eliminate the structural budget deficit (i.e. that part of the deficit unrelated to the stage of the economic cycle) by 2014/15, as he aimed for a fiscal consolidation of some 91 billion in coming years. Fitch, one of the leading ratings agencies, seemed to welcome the Emergency Budget, stating that it should materially strengthen confidence in the countrys public finances and its triple-A rating if the government can deliver its planned measures. In a press release, the rating agency said the budget sends a strong statement of intent by the new government that it will speed up deficit reduction and reduce the U.Ks debt burden. Source: Tutor2u economics blog, author Mo Tanweer