In These New Times

A new paradigm for a post-imperial world

Britain’s crushing debt burden

Posted by smeddum on May 1, 2009

Britain’s crushing debt burden

By Associate Editor David Stevenson May 01, 2009

Alistair Darling tried to magic it away with some fantasy growth projections. But a future Budget will have to get serious about Britain’s debt, says David Stevenson.

How bad are the numbers?
Awful. At £90bn, public-sector borrowing for the year to 5 April 2009 hit its highest since the early 1990s. Yet for this year, the Chancellor has pencilled in a deficit of nearly double that – £175bn. “It’s difficult to put into words the extent of the meltdown in the UK’s public finances,” says The Daily Telegraph’s Liam Halligan. “During his 2008 budget, Alistair Darling said the UK would borrow a total of £70bn during 2009/2110 and 2010/2011. Today we learnt that £348bn of new debts will be racked-up on our behalf over that period.” The future looks no brighter. Even on official figures, the public purse will have to borrow more than £700bn from gilt market investors between now and 2013/2014, a rise of more than 60% on Darling’s estimates in last November’s Pre-Budget Report.

What’s caused the shortfall?
The economic slump has hammered both sides of the ledger. Tax revenues are sagging as company profits plunge, meaning less corporation tax is collected, and stamp duty receipts are diving as fewer houses are sold. Dole queues are lengthening, with unemployment topping two million and rising fast. That reduces the income-tax take, while raising welfare payments. Yet what’s really scary is a sharp rise in the ‘structural’ budget deficit. The Institute for Fiscal Studies reckons that some £140bn of this year’s £175bn borrowing estimate is long-term ‘structural’ debt. This basically means that even in good times, as the system currently stands, the government spends a lot more than it can expect to generate from tax revenue. So even a swift economic bounce wouldn’t greatly improve the fiscal position.

Can the deficit get even worse?
Sadly, yes. The Chancellor admitted the economy will shrink by 3.5% this year, but hopes for a return to growth in 2010 of 1.25%, followed by 3.5% in 2011. That would cut the shortfall, but hardly anyone else is this bullish. In fact, Liberal Democrat Treasury spokesman Vince Cable described the growth predictions as “utter fantasy”. Within hours of Darling’s Budget, data showed that the UK economy shrank by 1.9% in the first quarter of 2009, far worse than expected. That was the sharpest quarterly annual output fall since 1979 and was followed by an immediate forecast from the International Monetary Fund (IMF) for a 4.1% GDP fall this year and a 0.4% drop in 2010. That’s all bad news for the public purse. Capital Economics believes that, at its peak, the government deficit will hit £230bn, some 16% of GDP and higher than any recorded peace-time year – eventually pushing the national debt to more than 100% of our annual output.

Will we be able to borrow enough?
Fears are growing that Britain may struggle to find enough future buyers for its bonds. Compared with that £700bn Treasury gilt sale forecast, Deutsche Bank believes the markets will actually be flooded with £815bn of new British government bonds. “The markets are running scared. If [the government] is going to hit us with this supply, the market will push up yields,” says Monument Securities’ Marc Ostwald. “It will increase debt service costs and the government will have to borrow more.” And there’s plenty more potential debt behind the scenes – Britain’s ‘off-balance sheet’ liabilities arising from the private finance initiative and the soaring public-sector pension deficit. Adding it all up, last month Numis Securities concluded that, by 2010, the UK’s underlying public debt will hit 280% of GDP.

So what’s the answer?
The soaring debt burden could mean the UK’s precious AAA sovereign credit rating being downgraded, raising interest rates for firms and consumers. That would force funds that can only invest in triple A-rated bonds to dump existing gilt holdings. That’s still unlikely, but “Treasury projections are a cause for concern”, says Arnaud Mares at credit ratings agency Moody’s. “This suggests fiscal policy will have to be tightened much further than currently envisaged.” In other words, tax hikes and state spending cuts are a must. “Difficult decisions on spending priorities lie ahead for whoever’s in government,” says the FT. David Cameron has now “prepared the ground for a dramatic 2010 Budget that would make cuts to public spending, including tight curbs on public sector pay and probable tax rises, softening up party and public opinion for what could be one of the most painful round of cuts since Sir Geoffrey Howe’s Budget in 1981”. The alternative – a return call to the IMF for a 1976-style bail-out, which would see cuts imposed upon us – would be even worse, and is to be avoided at all costs.

Can’t the government just raise income tax?
It’s not that simple. The hike to a 50% marginal tax rate for higher earners may have grabbed the headlines, but in fiscal terms it’s almost irrelevant. Even if those higher earners took no action at all, the Treasury would collect a hardly pivotal extra £3.6bn. But Mike Williams, the Treasury’s personal tax director, has admitted to MPs that the government expects to receive just 31% of that total, as higher-rate taxpayers use legal means to avoid handing half their incomes to the Chancellor. It all comes down to the Laffer Curve, which identifies the marginal rate at which the tax take is maximised. A 40% level is about right, reckoned the Institute for Fiscal Studies (IFS) last week – ie, high enough to bring cash in, but low enough not to encourage mass evasion – but 50% is a step too far. It now looks like the IFS got it spot on.

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