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Running deficits every year: Debt-to-GDP ratio
The preceding section makes clear that if a government runs a deficit today and funds it by borrowing, at some point in the future it has to pay it back. If that’s the case, surely in some years the government needs to run fiscal surpluses in order to balance the years of fiscal deficits.
But hang on a minute. The earlier Figure 11-1 clearly shows that isn’t the case in the UK (and indeed in most countries) – instead the tendency has been to run persistent deficits with only the occasional surplus. How is that possible?
The argument goes as follows. Although any year with a fiscal deficit increases the national debt, at the same time, countries tend to experience economic growth over time. People shouldn’t be concerned about how indebted a country is in absolute terms; they should consider how indebted the country is relative to how rich it is.
For this reason economists often look at what’s happening to the debt-to-GDP ratio over time. If it’s falling, most likely the country’s debt is sustainable. If it’s persistently rising, the country may have difficulty meeting its liabilities if it’s not careful.
Figure 11-3 shows that over time UK debt has tended to increase and that in recent years it has increased substantially. This is consistent with Figure 11-1, shown earlier, which shows that the UK has tended to run fiscal deficits and that these have been particularly large recently.
© John Wiley & Sons
Figure 11-3: UK debt.
In Figure 11-4, you can see that no clear trend exists in the UK’s debt-to-GDP ratio: at certain times (the 1980s) it fell; at other times (the 2000s) it rose.
© John Wiley & Sons
Figure 11-4: UK debt-to-GDP ratio.
Notice that even though UK debt has been steadily increasing over the years (with a few minor exceptions), the debt-to-GDP ratio has fallen at times because during those periods, GDP increased faster than the national debt:
A falling debt-to-GDP ratio is always good news, because it means that a nation’s finances look sustainable even if it’s running persistent deficits.
An increasing debt-to-GDP ratio is a matter of concern, because it indicates that a country’s debts are becoming less and less affordable.
So even though the UK’s national debt continues to increase, so too has GDP. You can see in Figure 11-4 that the UK’s debt-to-GDP ratio, although historically high, appears to be stabilising at around 80 per cent. And because the UK government is still able to borrow from financial markets at very low interest rates, it seems that investors think the UK Exchequer will pay back their loans eventually.
Raising a government’s revenue
In essence, a government can raise revenue to fund its expenditure in
three ways: taxes, bonds (which we argue are just delayed taxes) or seigniorage (printing money, which we argue leads to an inflation tax). Therefore, if bonds and printing money equate to taxes anyway, in practice a government has only one way to raise revenue: through taxation! Nonetheless, looking at each of these ways separately is useful.
Taxes
In the UK, annual government tax revenue equals around one-third of the country’s gross domestic product (GDP). Here are a few of the ways in which taxes are collected:
Income tax: The tax payable on earned income. For most people, earned income is their salary from working, but it also includes income from savings, rental income and dividend income from shares.
National insurance (NI): Originally paid to fund certain state benefits, NI is paid by workers and firms. Nowadays it’s similar to income tax, except that entitlement to the full state pension requires a certain number of years of NI contributions.
Corporation tax: Taxes paid by firms on their profits.
VAT: A tax levied on the consumption of goods and services. In the UK, VAT is 20 per cent on most goods, although items such as food and children’s clothes are excluded.
Duties: Ever wondered why petrol and cigarettes are so expensive? That’s right, a large portion of the price is a tax. Duties are a serious source of revenue for governments: for example, fuel duty earns the Exchequer more than £25 billion per year!
Taxes on capital: Taxes on things you own – includes capital gains tax, inheritance tax and stamp duty.
The revenue raised from taxes allows the government to purchase goods and services for the public, pay public servants and so on. It’s also used to redistribute income, typically (though not always!) from richer people to poorer people.
Strictly speaking, the revenues raised for redistributive purposes aren’t called taxes but transfers. Equally, when economists talk about government expenditure, they usually exclude transfers, because transfers only involve the transferring of purchasing power from some individuals to others – they don’t involve the purchase of goods and services.
Bonds
When the government runs a fiscal deficit, it has to make up the difference between spending and revenue somehow. Issuing bonds is the main way in which governments fund deficits. A bond is like an IOU, a piece of paper that promises to pay the owner some amount of money at a certain date in the future.
For example, the UK government could issue a bond that promises to pay the owner £10 million in 2025. It would sell the bond today in order to raise money. But how much would it be sold for? Well, in normal times, probably not more than £10 million because that would be silly (though see the nearby sidebar ‘Buying bonds doesn’t always make sense!’). Similarly, buying the bond today for exactly £10 million isn’t a particularly attractive prospect – the buyer would make nothing in nominal terms, and if inflation were positive, the holder would make a loss in real terms.
So the government is only likely to be able to sell the bond for less than its face value (£10 million), because bondholders expect compensation for lending the government money.
The lower the price the bond is sold for today, the higher the interest rate the government is paying for the loan.
Economists think of issuing bonds as deferred taxes, because when a government borrows money by issuing bonds, that money has to be repaid at some point in the future. And how will it be repaid? Well, by
future taxes of course.
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