Managing government spend and income is vitally important if an economy is to stay healthy; otherwise it can slide into a spiral of debt.
Governments set a budget for how much they want to spend, and they set tax rates which are designed to collect the necessary funds. But forecasting tax revenues is difficult: the level of economic activity in a country depends on unpredictable factors and upon the economies of other countries (3.3.5.2). If the economy grows less strongly than expected the tax revenues will be lower, and the costs of benefits will be higher, than budgeted.
In their desire to please people (particularly if an election is imminent) politicians tend to make over-optimistic assumptions. The British government’s decision to set up an Office for Budget Responsibility (OBR) in 2010 was intended to restore city confidence in economic forecasts. As BBC Economics editor Stephanie Flanders explained, in a blog post Why the Office for Budget Responsibility matters, this followed a period when “the revenue and borrowing forecasts in the latter years of the Labour government were objectively atrocious”.
Unfortunately, the rules that the OBR is obliged to follow do not prevent politicians from gaming the system. As explained by Simon Wren-Lewis, “the OBR is legally obliged to produce a forecast on the basis of what the government claims is its policy”. A budget can paint a rosy picture of the future by claiming that public spend will be reduced and/or tax will be reduced in later years, no matter how implausible the claims. Wren-Lewis argues that Chancellor Jeremy Hunt did exactly this in his budget of March 2023, putting forward policies “that almost certainly will not happen”.
If governments spend more than they receive in tax they have a so-called ‘fiscal deficit’ and they must borrow to make up the difference. This borrowing can create problems:
· The debt must be paid back, so tax will have to be higher in subsequent years: possibly placing a burden upon those who had no influence upon the decision to incur the debts and who had not benefited from the increased government spending at the time when the debt was incurred.
· If debt is incurred to fund current expenditure such as benefit payments, it amounts to theft from future taxpayers unless the debt is repaid within the life of the government which made the decision.
· If government borrowing in a restricted pool of available finance causes a rise in interest rates, its impact is to further reduce consumer demand and to increase the costs of wealth creation – preventing a return to economic growth.
· Markets will charge higher interest rates to a government if there is doubt whether it is managing government spend and income responsibly. A BBC article, Timeline: The unfolding eurozone crisis, recorded how some countries in difficulties faced increased borrowing costs during the Eurozone crisis in 2011. The increased rates further reduce those governments’ ability to repay their debts, in a vicious spiral.
· If governments control their own currencies, they can repay debts by printing money. This is inflationary and is a serious problem in itself, as described later (3.3.8.3).
It is evidently imprudent to allow debt to continually increase. If a government has entered into long-term commitments that exceed its average tax revenue it is running a so-called 'structural deficit' which is unsustainable and has to be corrected – either by cutting government spending or by increasing taxation. Such corrections are painful and reduce economic growth.
There are circumstances in which government debt can be allowed to increase temporarily without being irresponsible. If it incurs debt for making investments in infrastructure or research (3.2.3.2), which will benefit future generations, the borrowing can be justified morally and economically: creating jobs in the short term and contributing to economic growth in the longer term. And, as described next (3.3.8.2), a temporary increase in debt is justifiable when a government is trying to smooth out the economic cycle – but it must publish a credible plan to reduce the debt later.
(This is an archive of a page intended to form part of Edition 4 of the Patterns of Power series of books. The latest versions are at book contents).