Monday, April 27, 2009

Forecast for National Debt - Why Increase?

Just recently, I was teaching students about the chancellor's golden rule of borrowing - the rule that governments should not borrow more than 40% of GDP. Also over the course of the economic cycle, annual government borrowing should not exceed 3% of GDP. It was only quite recently this was frequently referred to by the government with a sense of pride. But, given the current state of finances, it will be one of those concepts the government will try to keep locked in a cupboard like an embarrassing old relative.

This year we are facing borrowing of over 12% of GDP and a public sector debt rising towards 80% of GDP (and this is with HM Treasuries optimistic forecasts)

The UK does not have the highest National Debt as a % of GDP (list of countries) but it has experienced one of the most rapid deteriorations. It is this rapid deterioration that has spooked the markets more than anything - it gives the impression the government are losing control. And it doesn't help the government's forecasts soon start to appear overly optimistic.

Why Has Debt Risen So Sharply?

Ambitious Spending Plans. For a brief time Labour pursued tight spending plans. This led to a brief budget surplus in 2000. However, the Labour Government then decided to increase real spending on health and education significantly. It was this large increases in spending that caused the UK to have a budget deficit of 2.7% of GDP even at the end of the economic boom in 2007.

Collapse in Tax Revenues. The scale of the recession (output fell a record 1.9% in the first quarter) and falling asset prices has hit tax revenues drastically. Government forecasts for tax revenues assumed full employment, rising house prices and growing tax receipts. But, the recession has caused the opposite.
  • Falling House prices and lower number of property transactions have reduced stamp duty
  • Rising unemployment and lower bonuses have hit income tax. 16% of the total income tax is paid by the top 1% of earners. It is these earners, especially in the city who have been hard hit by the credit crunch so income tax receipts have fallen.
  • Lower corporation tax. Falling profits leads to declining corporation tax
  • Bankruptcys. Rising number of bankrupt firms have led to large numbers of tax bills being left unpaid.
  • Lower VAT. Lower spending in addition to VAT cut to 15% have led to a fall in tax revenue.
The Sin taxes of petrol, alcohol and cigarettes are some of the few taxes that have not decreased in the past year.

Rising Unemployment. Unemployment costs the government in terms of jobseekers allowance, other benefits like housing benefits and lost income and NI allowances.

Rise in Economic Inactivity. In addition to rising unemployment there has been a rise in the number of economically inactive. Since 1997, the number not working (but not classed as unemployed) has risen by 250,000. For example, this could include incapacity benefit, sickness benefit.

Long Term Demographic Trends. Long term demographic trends will not help the UK deal with future debt burdens. The UK population is slowly ageing creating a bigger dependency ratio

Expansionary Fiscal Policy. To Deal with the Downturn the government cut some taxes and increased spending. This fiscal expansion amounted to 1.1% in November and an extra 0.5%. But as a % of the total rise in national debt, this fiscal expansion looks relatively small. Highlighting how disastrous the collapse in normal tax receipts have been

Bank Bailouts. The government have had to spend billions on buying shares in failing banks. According to the IMF, Britain has already spent nearly 20% of GDP on bailing out the banks. (Guardian)


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