From “How Stuff Works”


Alistair Darling, the UK’s Finance Minister, announced in the House of Commons today a raft of measures which the government hopes with act as a catalyst to spark new growth in the dwindling economy, injecting £22 billion into the UK economy.  Chief amongst those measures is an immediate decrease in Value Added Tax (VAT), the sales tax forced upon the UK when it joined the European Communities on New Year’s Day, 1973.  The VAT rate will be reduced from 17.5% to 15%.  Pensioners and those on low incomes or benefits will also receive more money.  This is to be funded by an increase in government borrowing.  The pound immediately increased in value against the dollar, reversing its previous sharp decline. Markets rose by unprecedented amounts.

The money that governments spend comes from revenue or from borrowing.  Revenue from taxes is an important part of a government’s overall revenue.  If it cuts taxes, it gets less revenue, and if it wants to continue spending at previous levels or increase spending, then it will need to replace that lost revenue from elsewhere, typically by borrowing.

Government borrowing generally takes the form of issuing government bonds backed by the national bank.  These bonds may be bought by other governments or by other investors.  In the UK small private investors can buy National Savings Certificates and Premium Bonds – both forms of government borrowing.  The huge government deficit in Japan is almost entirely funded by the investment of private Japanese savers in government bonds: in the US the position is different – very little of government borrowing is funded by domestic investments (less than 25%).

Government borrowing is thought to be a bad thing, especially by Conservatives everywhere in the world. I now turn to Geoff Riley, Head of Economics at Eton College, David Cameron’s old school, to tell us why: 

There is a consensus that a persistently large budget deficit can turn out to be a major problem for the government and the economy. Three of the reasons for this are as follows:

1.  Financing a deficit: A budget deficit has to be financed and day-today, the issue of new government debt to domestic or overseas investors can do this. But it may be that if the budget deficit rises to a high level, the government may have to offer higher interest rates to attract buyers of government debt. In the long run, higher government borrowing today may mean that taxes will  have to rise in the future and this would put a squeeze on spending by private sector businesses and millions of households.

2.  A government debt mountain? In the long run, a high level of government borrowing adds to the accumulated National Debt. This means that the Government has to spend more each year in debt-interest payments to holders of government bonds and other securities. There is an opportunity cost involved here because interest payments might be used in more productive ways, for example an increase in spending on health services. It also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy

3.  Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of government spending. They believe that a rising share of GDP taken by the state sector has a negative effect on the growth of the private sector of the economy. They are sceptical about the benefits of higher spending believing that the scale of waste in the public sector is high – money that would be better off being used by the private sector.

As a rule, it is thought that government borrowing of more than 3% of Gross Domestic Product (GDP) and a National Debt of more than 60% of a country’s GDP is harmful.  Within the Euro-zone the Stability and Growth Pact set out in the Maastrict Treaty defined borrowing of more than 3% as “excessive” and Member States are obliged to try to keep within this limit.

CIA compiled figures on the level of national debt as a percentage of GDP are presented here. The UK (43%)appears below other European countries such as Italy (104%), Norway (83.10%), Germany (64.90%) and below the US (60.90%).  Japan’s debt runs at 170% of GDP.

The UK is not bound by the Maastrict provisions because it is outside the Euro-zone, but Italy, France and Germany all have annual borrowing above the 3% limit.  The UK under the stewardship of Gordon Brown as, first, Chancellor of the Exchequor and, now, Prime Minister has meanwhile striven to keep borrowing below 2% of GDP although the UK used to run without a deficit in the 1990s and only began to have any borrowings when public spending on health and education, in particular, increased under the Labour administration.

Currently, the budget deficit (that is, the deficit between taxes and spending) is at its highest since immediately after the Second World War.  Critics of the Government argue that the acknowledged deficit figure does not represent the true scale of borrowing – because it does not include civil servant pension liabilities nor liabilities under Public Finance Initiatives (PFIs). 

Government borrowing has historically run at a deficit, worst in the mid- to late-1970s, although there was a short period of budget surplus in the late 1980s during a period of strong economic growth under Margaret Thatcher’s government (which turned into the last deep recession).  Because, returning to Geoff Riley, the question of government borrowing is a vexed one, and there are advantages, too, of governments running a deficit:

Two main arguments stand out

1.  Government borrowing can benefit economic growth: A budget deficit can have positive macroeconomic effects in the long run if it is used to finance extra capital spending that leads to an increase in the stock of national assets. For example, higher spending on the transport infrastructure improves the supply-side capacity of the economy promoting long-run growth. And increased public-sector investment in health and education can bring positive effects on labour productivity and employment. The social benefits of increased capital spending can be estimated through use of cost-benefit analysis.

2.  The budget deficit as a tool of demand management: Keynesian economists would support the use of changing the level of borrowing as a way of fine-tuning or managing the level of aggregate demand. An increase in borrowing can be a stimulus to demand when other sectors of the economy are suffering from weak spending. The fiscal stimulus given to the British economy during 2002-2005 has been important in stabilizing demand and output at a time of global uncertainty. The argument is that the government can and should use fiscal policy to keep real national output closer to potential GDP so that we avoid a large negative output Maintaining a high level of demand helps to sustain growth and keep unemployment low.

So we have the Government arguing that the increase in government borrowing (made necessary by the announcement today of cuts in VAT, and increases in benefits and allowances) is an essential tool to kick-start the economy and revive it from its recessionary spiral.  The proposals break Gordon Brown’s own Golden Rule – that borrowing is only permissable to finance investment, not to fund day-to-day spending, and also take the UK outside the Maastrict limit.  Exceptional times call for exceptional measures, the Government would argue, and claims that it has the backing of other major economies around the world who will follow suit with similar measures.

On the other hand, the Conservatives, ever mistrusting increased borrowing, argue that it will have an inflationary effect, and that the value of the pound against other major currencies will fall still further.  Immediate reaction in the currency markets tends to suggest that this latter point is unlikely to be true, and that the fall of the pound against the dollar, in particular, reflected its previously inflated value.

Ever prudent, the Chancellor, under Gordon Brown’s tutelage, proposes to ensure that Government borrowing is brought back below the desirable limits by increased tax revenue raised by the improved economic climate (the Government hopes to have reversed the recession by 2010) and by an increase in taxes for the wealthy.  Tax rates will be raised to 45% on income over £125,000 in 2011, raising about £2 billion in extra revenue, and national insurance contributions (paid by employers and employees) will increase by 0.5% at the same time.

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I’m not quite sure what the Conservatives think the Government should have done.  Nothing, I think.  I heard a pensioner saying she thought that it would have been better to target the VAT reductions by removing VAT from fuel bills – gas, electricity – and by giving greater concessions in relation to the local Council Tax. But I think the Government is more interested in creating a “feel good” factor than putting more money in the purse of stretched families. It wants people to start spending again – and that it not about giving them more to spend, but making them feel better, safer, about spending what they already have.  See above …