Thursday, November 20, 2008

National Debt Explanation

One Myth of National Debt - "An increase in government borrowing means taxes will have to rise in the future."

This seems so obvious that it is repeated as an unquestionable truth. However, it is not necessarily the case.

Let us assume:
  • Economic growth of 2.5% (The UK has average growth of 2.5% since 1945)
  • The government increase spending by 1% in real terms. (this takes into account inflation) but don't change tax rates,
  • If we have economic growth of 2.5%, this means that tax revenues will be rising by approximately 2.5%.
  • People will pay more income tax (even if rate stays at 23%)
  • People will buy more so the government will receive more VAT (even if rate stays at 17.5%)
  • Companies will pay more corporation tax.
Therefore, although the government is increasing its real spending (1%), its real tax revenue is increasing at a faster rate (2.5%). Therefore, government borrowing will be falling.

national debt

Falling National Debt as % of GDP
  • If government increases spending by 3%. Then government borrowing will have to increase because spending is rising faster than tax revenues. Therefore, National debt will be increasing in real terms.
  • However, although borrowing increases by 0.5%. Economic growth is higher 2.5%. Therefore, even though the government is borrowing more, national debt as a % of GDP is falling. If National debt as a % of GDP is falling, then a smaller % of tax revenues are needed to finance the government's debt interest payments.
  • For example, in 1997, government borrowing was £18 billion for the year, but national debt as a % of GDP fell.
  • Between 1998 and 2000, the government budget actually had a surplus, leading to a sharp fall in national debt as % of GDP)
Increasing National Debt as a % of GDP

The problem comes when the government increase borrowing at a rate faster than economic growth. In the period 2003-07, the UK significantly increased the government spending on NHS and education, this caused government borrowing to rise faster than the rate of economic growth. Therefore, public sector debt as a % of GDP increased from 29% to 35% of GDP.

Now, we are in recession, tax revenues are falling and government borrowing is increasing, therefore, we will see a sharp rise in national debt as a % of GDP. It will increase the % of GDP we have to devote to interest payments on national debt.

One reason Japan has such as a high national debt as % of GDP is that it has borrowed and there has been stagnant growth for over a decade.
  • However, when the UK returns to normal growth patterns (and it may take longer than we would like), we should see national debt as a % of GDP fall.
  • Therefore, increased borrowing doesn't necessarily have to lead to higher taxes in the future.
  • The other argument is that government borrowing stimulates the economy and as the economy grows, tax revenues will rise to pay off the temporary borrowing.

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