Tag: COVID-19 and the public finances

On 25 November, the UK government published its Spending Review 2020. This gives details of estimated government expenditure for the current financial year, 2020/21, and plans for government expenditure and the likely totals for 2021/22.

The focus of the Review is specifically on the effects of and responses to the coronavirus pandemic. It does not consider the effects of Brexit, with or without a trade deal, or plans for taxation. The Review is based on forecasts by the Office for Budget Responsibility (OBR). Because of the high degree of uncertainty over the spread of the disease and the timing and efficacy of vaccines, the OBR gives three forecast values for most variables – pessimistic, central and optimistic.

According to the central forecast, real GDP is set to decline by 11.3% in 2020, the largest one-year fall since the Great Frost of 1709. The economy is then set to ‘bounce back’ (somewhat), with GDP rising by 5.2% in 2021.

Unemployment will rise from 3.9% in 2019 to a peak of 7.5% in mid-2021, after the furlough scheme and other support for employers is withdrawn.

This blog focuses at the impact on government borrowing and debt and the implications for the future – both the funding of the debt and ways of reducing it.

Soaring government deficits and debt


Government expenditure during the pandemic has risen sharply through measures such as the furlough scheme, the Self-Employment Income Support Scheme and various business loans. This, combined with falling tax revenue, as incomes and consumer expenditure have declined, has led to a rise in public-sector net borrowing (PSNB) from 2.5% of GDP in 2019/20 to a central forecast of 19% for 2020/21 – the largest since World War II. By 2025/26 it is still forecast to be 3.9% of GDP. The figure has also been pushed up by a fall in nominal GDP for 2020/21 (the denominator) by nearly 7%. (Click here for a PowerPoint of the above chart.)

The high levels of PSNB are pushing up public-sector net debt (PSNB). This is forecast to rise from 85.5% of GDP in 2019/20 to 105.2% in 2020/21, peaking at 109.4% in 2023/24.

The exceptionally high deficit and debt levels will mean that the government misses by a very large margin its three borrowing and debt targets set out in the latest (Autumn 2016) ‘Charter for Budget Responsibility‘. These are:

  • to reduce cyclically-adjusted public-sector net borrowing to below 2% of GDP by 2020/21;
  • for public-sector net debt as a percentage of GDP to be falling in 2020/21;
  • for overall borrowing to be zero or in surplus by 2025/26.

But, as the Chancellor said in presenting the Review:

Our health emergency is not yet over. And our economic emergency has only just begun. So our immediate priority is to protect people’s lives and livelihoods.

Putting the public finances on a sustainable footing

Running a large budget deficit in an emergency is an essential policy for dealing with the massive decline in aggregate demand and for supporting those who have, or otherwise would have, lost their jobs. But what of the longer-term implications? What are the options for dealing with the high levels of debt?

1. Raising taxes. This tends to be the preferred approach of those on the left, who want to protect or improve public services. For them, the use of higher progressive taxes, such as income tax, or corporation tax or capital gains tax, are a means of funding such services and of providing support for those on lower incomes. There has been much discussion of the possibility of finding a way of taxing large tech companies, which are able to avoid taxes by declaring very low profits by diverting them to tax havens.

2. Cutting government expenditure. This is the traditional preference of those on the right, who prefer to cut the overall size of the state and thus allow for lower taxes. However, this is difficult to do without cutting vital services. Indeed, there is pressure to have higher government expenditure over the longer term to finance infrastructure investment – something supported by the Conservative government.

A downside of either of the above is that they squeeze aggregate demand and hence may slow the recovery. There was much discussion after the financial crisis over whether ‘austerity policies’ hindered the recovery and whether they created negative supply-side effects by dampening investment.

3. Accepting higher levels of debt into the longer term. This is a possible response as long as interest rates remain at record low levels. With depressed demand, loose monetary policy may be sustainable over a number of years. Quantitative easing depresses bond yields and makes it cheaper for governments to finance borrowing. Servicing high levels of debt may be quite affordable.

The problem is if inflation begins to rise. Even with lower aggregate demand, if aggregate supply has fallen faster because of bankruptcies and lack of investment, there may be upward pressure on prices. The Bank of England may have to raise interest rates, making it more expensive for the government to service its debts.

Another problem with not reducing the debt is that if another emergency occurs in the future, there will be less scope for further borrowing to support the economy.

4. Higher growth ‘deals’ with the deficit and reduces debt. In this scenario, austerity would be unnecessary. This is the ‘golden’ scenario – for the country to grow its way out of the problem. Higher output and incomes leads to higher tax revenues, and lower unemployment leads to lower expenditure on unemployment benefits. The crucial question is the relationship between aggregate demand and supply. For growth to be sustainable and shrink the debt/GDP ratio, aggregate demand must expand steadily in line with the growth in aggregate supply. The faster aggregate supply can grow, the faster can aggregate demand. In other words, the faster the growth in potential GDP, the faster can be the sustainable rate of growth of actual GDP and the faster can the debt/GDP ratio shrink.

One of the key issues is the degree of economic ‘scarring’ from the pandemic and the associated restrictions on economic activity. The bigger the decline in potential output from the closure of firms and the greater the deskilling of workers who have been laid off, the harder it will be for the economy to recover and the longer high deficits are likely to persist.

Another issue is the lack of labour productivity growth in the UK in recent years. If labour productivity does not increase, this will severely restrict the growth in potential output. Focusing on training and examining incentives, work practices and pay structures are necessary if productivity is to rise significantly. So too is finding ways to encourage firms to increase investment in new technologies.

Podcast and videos

Articles

OBR Data

Questions

  1. What is the significance of the relationship between the rate of economic growth and the rate of interest for financing public-sector debt over the longer term?
  2. What can the government do to encourage investment in the economy?
  3. Using OBR data, find out what has happened to the output gap over the past few years and what is forecast to happen to it over the next five years. Explain the significance of the figures.
  4. Distinguish between demand-side and supply-side policies. How would you characterise the policies to tackle public-sector net debt in terms of this distinction? Do the policies have a mixture of demand- and supply-side effects?
  5. Choose two other developed countries. Examine how their their public finances have been affected by the coronavirus pandemic and the policies they are adopting to tackle the economic effects of the pandemic.

In a little over a decade economies around the world have experienced two ‘once-in-a-lifetime’ shocks. First, there was the global financial crisis of the late 2000s, which saw an unsustainable expansion of banks’ balance sheets that resulted in a global economic slowdown. Now in 2020, a global health emergency has meant unprecedented falls in economic activity. In both cases, the public sector has been the economy’s shock absorber but this has had dramatic effects on its financial wellbeing. We consider here the effect on the UK public finances and reflect on their sustainability in light of the recent Fiscal Sustainability Report published by the Office of Budget Responsibility (OBR).

The COVID-19 pandemic saw the government initiate a range of fiscal interventions to support people and businesses. Interventions directly affecting public-sector spending included a series of employment support measures. These included the Coronavirus Job Retention Scheme, commonly referred to as the furlough scheme, the Self-employed Income Support scheme, a ‘Kickstart Scheme’ of work placements for universal credit recipients aged between 16 and 24 and a ‘Job Retention Bonus’ whereby employers can receive a one-off payment of £1,000 for every furloughed employee continuously employed from the cessation of the Job Retention Scheme on 31 October through to 31 January 2021.

Further spending interventions have included small business grant schemes, such as the Coronavirus Small Business Grant Fund, the coronavirus Retail, Hospitality and Leisure Grant Fund and the Coronavirus Local Authority Discretionary Grants Fund.

Meanwhile, taxation relief measures have included a business rates holiday for retail, hospitality and leisure businesses and a reduced rate of VAT of 5 per cent for hospitality, accommodation and attractions until 12 January 2021.

OBR’s central scenario

The OBR in its Fiscal Stability Report in July 2020 attempts to assess the wellbeing of the public finances not just in the short term but in the medium and longer term too. This longer-term perspective allows it to assess the sustainability of the public finances.

Its analysis is based on some key assumptions, including population growth and future demands on public services, but, understandably, the timing of this report has necessitated some key assumptions around path of the economy, including the extent to which the economy will experience scarring effects, also known as hysteresis effects. While the analysis does not incorporate the Chancellor’s measures announced in its summer statement on the 8 July, including the kickstart scheme, job retention bonus and the reduced rate of VAT, which would have a material effect on this year’s numbers, the OBR concludes that there would be less significant impact on its medium-term analysis.

In what it describes as its ‘central scenario’ the OBR forecasts that national output (real GDP) will fall by 12 per cent in 2020 before growing by 9 per cent in 2021 and 4 per cent in 2022. National output therefore reaches its pre-virus peak at the end of 2022. However, 20 quarters on from the pandemic shock in Q1 2020 output is estimated to be 3.2 per cent less than it would otherwise have been, while the cumulative loss of output is expected to be 6.4 per cent over the period. The cumulative loss of output in the 20 quarters following the financial crisis (Q2 2008) is estimated to have been 9.3 per cent of actual cumulative output.

While national output is expected to be permanently lower because of the pandemic, consistent with hysteresis, the forecast assumes that the longer-term growth rate is unaffected. In other words, there is not expected to be what some now refer to as ‘super hysteresis’, whereby the scarring effects have persistent effects on rates of capital accumulation, innovation and productivity, which therefore depress structural economic growth rates.

Meanwhile, the unemployment rate is expected to peak at 11.9 per cent in the final quarter of this year, before falling to 8.8 per cent in Q4 2021 and 6.3 per cent in Q4 2022. By Q4 2025 the unemployment rate is forecast to be 5.1 per cent, one percentage point higher than the OBR was forecasting at the time of the Budget in March.

Spending and receipts

Chart 1 shows shows the predicted paths of (nominal) public-sector receipts and expenditures as a percentage of (nominal) GDP. Receipts are expected come in at £740 billion this financial year (excluding the impact of the summer statement measures), some £133 billion lower than was forecast at the time of the March budget. This will amount to a 10 per cent fall in receipts in the financial year, driven by a much-shrunken economy. However, the fact that nominal GDP falls somewhat more means that the receipts-to-GDP ratio ticks up slightly. (Click here for a PowerPoint of the chart.)

Public-sector spending is expected to be higher in 2020/21 than was forecast in the March by £135 million (excluding the summer statement measures) reflecting the COVID-19 interventions. This would result in spending rising to £1.06 trillion, a 20 per cent rise in the financial year. It would also mean that public-sector spending as a share of GDP rises to 54 per cent – its highest since 1945/46.

Going forward, in cash terms receipts are permanently lower than forecast because GDP is lower, though as a share of GDP cash receipts increase very slightly, but remain below what was expected at the time of the March budget. Spending in cash terms is expected to fall back by close to 8 per cent next financial year before increasing by 3 per cent per year up to 2024/25. This means that the spending-to-GDP ratio falls back to around 43 per cent by 2024/25, a couple of percentage points higher than was forecast back in March.

Deficits and debt

The difference between spending and receipts is known as public-sector net borrowing. While the extent of borrowing can be inferred by inspection of Chart 1, it can be seen more readily in Chart 2 which plots the path of public-sector net borrowing as a share of GDP.

The OBR is now forecasting a budget deficit of £322 billion (excluding the summer statement measures) in 2020/21 compared to £55 billion at the time of the March Budget. This would be equivalent to over 16 per cent of GDP, the highest since the Second World War. In a follow-up presentation on the Fiscal Stability Report on the 14 July the OBR suggested that the inclusion of summer statement measures could mean the deficit being as high as £375 billion, implying a deficit-to-GDP ratio of just shy of 19 per cent. (Click here for a PowerPoint of the chart.)

Deficits represent borrowing and are therefore a flow concept. The accumulated deficits over the years (minus any surpluses) gives total debt, which is a stock concept. The public-sector’s net debt is its gross debt less its liquid assets, principally deposits held with financial institutions and holdings of international reserves. This is also affected by Bank of England interventions, such as the Term Funding Scheme which enables banks and building societies to borrow funds at close to Bank Rate for up to four years. Nonetheless, the key driver of net debt-to-GDP ratio going forward is the persistence of deficits.

Chart 3 shows the expected path of the net debt-to-GDP ratio. The OBR expects this to exceed 100 per cent in 2020/21 for the first time since 1960/61. This reflects an increase in cash terms of the stock of net debt to £2.2 trillion, up from £1.8 trillion at the end of 2019/20, as well as a fall in GDP. By 2024/25 the net debt stock is expected to have risen to £2.6 trillion, £600 billion more than expected at the time of the March budget, with the net debt-to-GDP ratio still above 100 per cent at 102.1 per cent. (Click herefor a PowerPoint of the chart.)

Sustainability

The higher debt-to-GDP ratio raises longer-term questions about the sustainability of the public finances. The government is currently reviewing its fiscal rules and is expected to report back in time for the autumn budget. A key question is what debt-stabilising level might be considered appropriate. Is it the 102 per cent that the OBR is predicting at the end of 2024/25 (the medium-term horizon)? Or is it the 75 per cent that was being forecast for this point back in the March budget? This has profound implications for the fiscal arithmetic and, specifically, for the primary balance (the difference between non-interest spending and receipts) that the public sector needs to run.

If the government accepts a higher debt-to-GDP ratio as a ‘new norm’ that eases the fiscal arithmetic somewhat. However, some economists would be concerned about the economic consequences of larger public-sector debts, most notably so-called potential crowding-out effects on private-sector investment if upward pressure on interest rates was to materialise (see the news item MMT – a Magic Money Tree or Modern Monetary Theory?).

Even if the higher stabilising debt level was deemed appropriate, the OBR’s report analysis suggests problems in the government meeting this because it could still be running a primary deficit of 3.7 per cent of GDP by 2024/25. Therefore, even with interest rates expected to be lower than economic growth rates in 2024/25 (a negative growth-corrected interest rate) that enable governments to run primary deficits and yet maintain debt-to-GDP ratios, the debt-stabilising primary deficit for 2024/25 is estimated at only 3.2 per cent. All in all, this points to difficult fiscal choices ahead.

Articles

Questions

  1. What do you understand by the term financial wellbeing? What might this mean in respect of the government?
  2. What is meant by the fiscal arithmetic of government debt? Explain the factors that determine the fiscal arithmetic and the path of government debt?
  3. What is the difference between an increase in the size of a government deficit and an increase in the stock of government debt?
  4. Discuss the economic argument that, following the COVID-19 pandemic, government should avoid a return to an agenda of fiscal austerity ?
  5. What is the difference between the budget deficit, the primary deficit and the structural deficit?
  6. What are hysteresis effects? Discuss their relevancy in the design of the UK’s COVID-19 interventions.