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.
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)
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.