Two reasons why the public finances are in deep trouble

Circulation in macroeconomics

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Last time the UK’s public finances were in such a mess was back in the 70’s. A whole lot of pain was inflicted on the public, including austere spending cuts imposed by the IMF.

In the end a Tory government was voted in. The government was forced to hike taxes and cut public spending. In the end they were able to right the ship.

Thatcher talked about government finances being like a household budget. This simple analogy can be useful – i.e. you shouldn’t spend more money than you bring home.
But there are two critical differences…

First, when a household borrows it’s usually to buy something tangible (a house, or a car). Yes, you’ve created a liability (the loan), but there’s an asset on the other side of the balance sheet.

Secondly, households tend to borrow most when they’re young. Borrowers work on the assumption that their wage will tend to rise over time, so reducing the onus of the loan.

Neither of these applies to government borrowing.

Firstly, government borrowing generally isn’t for investment. The big bills are for NHS, schools, welfare benefits and pensions. That’s not to mention the banking bail-outs. This is day to day spending – and it keeps going up!

Anyway, if there has been investment, it’s been mainly pushed off the balance sheet into PFI projects. There are no new assets on the government’s balance sheet.
Secondly, the government can’t easily grow its income. They can try to increase revenue by upping taxes, but this is increasingly difficult…
In economics the ‘Laffer curve’* describes how you can only raise taxes to a certain point after which the amount of money raised actually begins to go down. And that’s where we are now.

* Not an original idea. David Hume expressed similar arguments in his essay Of Taxes in 1756, as did fellow Scottish economist Adam Smith, twenty years later. But even they weren’t entirely original.

Businesses are migrating to lower tax regimes and so are individuals. Of course, this all takes time, but make no mistake, people aren’t happy to offer government a blank cheque book.

Once presented with unreasonable taxes people start to avoid them, both legally through avoidance and illegally through evasion.

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