Is the UK deficit too high only because economic growth has stopped?

Posted by Tim Congdon in News Archive | 0 comments

A commonly-expressed view in the media is that Chancellor Osborne’s failure to curb the budget deficit is due to weak tax revenues, which in turn are to be explained by the economy’s weak supply-side performance. According to this analysis, the economy’s inability to generate more tax revenue is attributable to its more fundamental inability to increase output at all. Since supply-side remedies take a long time to work. Osborne is by implication not to blame for the persistence of budget deficits in the range of 5% – 10% of gross domestic product.

In the note below I dispute this position. I show that in the last few quarters the Conservative-LibDem coalition government has let general government consumption rise faster than total national expenditure, which is dominated by the private sector. General government  consumption is not to be seen as equivalent to total public expenditure, which also includes capital expenditure and transfer payments [i.e., welfare expenditure, pensions, debt interest]. Nevertheless, a government genuinely committed cutting the  deficit would have made a better job at trimming public expenditure.

Osborne’s deficit setback: due to low growth and weak revenue only?

Public sector net borrowing is expected to be about £120 billion in the coming 2013/14 fiscal year, much as it was in 2012/13. The Office for Budget Responsibility has correctly said that Mr. Osborne’s campaign to reduce the budget deficit has ‘stalled’. As a result, public debt will rise faster than national income this year and next. Even more worrying are the medium- and long-term prospects for the UK’s public finances. In documents published with the Budget the OBR sets out a plan with assurances are that, on present policies, the debt/GDP will peak in 2017. But it had previously given assurances that the debt/GDP would peak two or three years earlier, and it was wrong.

The economy’s weaker-than-expected growth performance is often mentioned as the main cause of the disappointing fiscal arithmetic. Since the start of the Conservative-LibDem coalition government in 2010, growth of national output has been lower than envisaged. As tax revenues are a proportion of national output, they also have been lower than forecast. On this basis the blame for the above-target deficit outturns lies with the ‘supply side’ of the economy, which is understood as having less dynamism than in the 1980s and 1990s for all sorts of reasons that cannot be immediately remedied. Osborne has not yet been criticized because of unsatisfactory control of public expenditure. Indeed, the standard badmouthing he receives from ‘the left’ in British politics is that he has been too austere (or even ‘too austerian’, to quote Paul Krugman’s neologism in his 2011 book End this Depression Now!). The left seems to think that Osborne has been dogmatic and uncaring in his commitment to lowering public expenditure. My argument here is that some important evidence does not support this view. On the contrary, Osborne has not reduced general government consumption at all.Government spending and the economy since the election of New Labour

The chart above shows the annual growth rates of total domestic expenditure and general government consumption, on a quarterly basis, since the election of New Labour in 1997. The usual political narrative  of  this  period  had  well-known  messages  for  public  expenditure,  many  of  which  are confirmed by the chart.  In its first 18 months to two years New Labour left the Conservatives’ overall spending plans unchanged, so that total domestic expenditure (and hence tax revenues) rose faster than government spending. New Labour therefore had a budget surplus, enabling Gordon Brown to acquire his reputation for ‘prudence’. The Great Recession appears in the chart as the 6% – 7% plunge in total domestic expenditure in the year to the first half of 2009. Gordon Brown reacted to the Great Recession by so-called ‘Keynesian fiscal reflation’, so that government consumption continued to grow even as private spending and the government’s tax revenues fell. That led to the sharp widening in the budget deficit recorded between 2007 and 2010, and the destruction of Gordon Brown’s reputation for ‘prudence’, managerial competence and much else. (Note that public expenditure is much larger than general government consumption. It includes capital expenditure, which can be volatile, and a wide range of transfer payments, notably welfare benefits and debt interest. The government has less definite control over these transfer payments than of its ‘consumption’, which is dominated by expenditure on health and education. Note also that the numbers in the chart are taken from the national income accounts, which are prepared on a basis somewhat different from the Treasury’s expenditure figures in the Budget documents. At the time of writing, the national accounts end in the third quarter of 2012 and the estimates for general government consumption may be revised.)Government spending and the economy since the election of the Conservative/LibDem coalition

But government spending is rising in real terms – and faster than private sector spending

After the change of government in 2010 the first few quarters appear to suggest a move to austerity. The annual change in general government consumption was negative in each of the four quarters to the second quarter of 2011. (Remember, incidentally, that half of the year to the fourth quarter of 2010 was still under a Labour government, so that the expenditure restraint was not all due to the new coalition.) Meanwhile the rebound in the economy in 2010 and early 2011 boosted tax revenues, causing the budget deficit to drop significantly from 11% of GDP in 2009/10 to 8% of GDP in 2011/12. Osborne’s Plan A seemed to be in place and the UK retained its triple-A credit rating.

But look at what has happened since 2011. In the last few quarters for which data are available (i.e., up to the third quarter of 2012), general government consumption was rising faster than total expenditure in the economy. The point is brought out more clearly in the chart above, which relates to the period since 2009 and so now increasingly reflects decisions taken by the coalition government. On  this  basis  the  claims  of  tight  expenditure  control  under  the  coalition  governments,  and  the polemics about an unjustified move to austerity, are invalid. Total expenditure in the economy is predominantly expenditure by the private sector. Whereas it has been barely growing since 2011, general government consumption has been increasing at about 2% – 3% a year.

It is therefore not true that the setbacks on the budget deficit are entirely to be attributed to weak  tax  revenues  and  the  inability  of  the  economy  to  expand  because  of  supply-side constraints. The setbacks on the budget deficit are also to be explained by rising public expenditure. To repeat, Osborne and his team have a more definite responsibility to control government consumption than the government’s transfer payments, the levels of which are set partly by statute and the economy’s performance (as with welfare benefits) and partly by conditions in the government debt market (as with debt interest). But an obvious link holds between control of government consumption expenditure and the budget deficit, and then between the budget deficit and the burden of debt interest. (Of course the higher is the budget deficit, the greater is the increase in the national debt and – for any given average interest rate on the debt – in the debt interest that has to be paid on the debt.)

The analysis in this note suggests that so far Osborne’s record in curbing the budget deficit has been at  best  mediocre.  In  the last  few  quarters  he  has  allowed  government  consumption  to  increase noticeably in real terms. That is one reason why the budget deficit will remain well above 5% of GDP when the present Conservative-LibDem coalition government comes to an end.

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