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Article taken from:

Quarterly Bulletin
Winter Edition
January 2010

How bad are the UK's public finances?

• In common with most countries, the UK's budget deficit has ballooned recently
• Our annual budget deficit is indeed among the worst in Europe
• But our total debt level is still lower than in many other developed economies
• The pain involved in eliminating the problem is daunting, but there is no immediate crisis

There has been much publicity in recent months about the sharp deterioration in the government’s finances, in this country and indeed in most countries in the developed world. Many of you have been asking us what the ramifications of this are for investors and taxpayers.

The UK’s budget has indeed deteriorated in the last year in a way without precedent in recent history. Absolute numbers have little relevance without reference to the size of the potential tax take, and one therefore needs to look at the size of the national debt as a proportion of national income or GDP. Until 2007 the UK had been running an annual budget deficit of 2-3% of Gross Domestic Product (GDP) for some years: this rose sharply in 2008 and has deteriorated even more quickly this year. The Treasury now expects the figure to be more than 12% and some external forecasters fear it will be nearer 14%.

We often read that our fiscal situation is worse than in other major economies. Whilst this does have a grain of truth in one respect, it is seriously misleading in another. It IS true that, as an annual percentage of GDP, that 12-14% per annum figure is among the worst in Europe - only Iceland and Ireland will probably have higher deficits this year. It will require painful action to bring that figure back to a sustainable level. However, it is NOT true that the UK’s total aggregate level of debt is high by international standards.

Privatisation receipts and other asset sales, allied to relatively prudent budgeting over most of the last generation, have meant that Britain’s aggregate debt ratio has actually been lower than in most of the developed world. Even after the bank bailouts and sharp fall in tax receipts this year, our total debt level remains comfortably mid-table. We are NOT about to have to seek emergency funding from the IMF, and the risk of the UK defaulting on its debt really should not keep anyone awake.
Nevertheless, such a high annual deficit is not sustainable in the long term. The Institute of Fiscal Studies estimates that the structural annual budget deficit, adjusted for cyclical effects, has grown by 6.5% of GDP - approximately £90bn - as a result of recent events. To put those numbers in perspective, a 1p rise in the basic rate of income tax yields the Treasury about £4bn.

Even after the recession fades, the consequences of the credit crunch for tax revenues will persist for many years. Most obviously, the large amounts of corporation tax on profits paid by the likes of Royal Bank of Scotland will not quickly be replaced. Likewise house prices, and therefore stamp duty receipts, are likely to take many years to recover fully. Capital gains tax receipts will also not improve quickly, and of course the ongoing annual interest cost of servicing the new debt will be increasingly onerous.

As Britain was already close to its self-imposed, but not unduly conservative, budget limits before the banking crisis, substantially all of the recent growth in the deficit needs to be eliminated over time. To leave the deficit at this level would eventually cause UK interest rates to rise sharply, to pay the interest on the government’s debt. This would be very detrimental. It would inevitably lead to further Sterling weakness, probably also to inflation and ultimately to effective financial paralysis.

Such a threat is not imminent. The aggregate level of debt reduces the urgency to take action, and most experts say that the Treasury should seek to reduce it gradually, over about 8-10 years. Indeed to try to reduce the deficit quickly at the same time that interest rates are returning to normal levels would be likely to do more harm than good to the economy.

So Britain isn’t about to go bankrupt. We aren’t going to find our tax bills doubling overnight: but firm action is needed and one obviously can’t save £90bn a year just by buying Whitehall’s paper clips more economically. So far none of the political parties have come up with proposals that come close to eradicating the gap and markets do need to see a coherent strategy for doing so soon. Even a gradual fiscal tightening of this magnitude is going to create almost universal pain. While the detail of how it will be done is best left to a later article after next year’s election, three or four themes stand out.

It seems inevitable that public sector pay (and, especially, pensions) will feel a squeeze which would have hitherto been deemed political suicide. One fears that an acceleration of the timetable for the rise in the pensionable age will be considered too, no doubt quietly at first. Either a rise in VAT levels or an extension of its base seems probable as well. Much current spending will prove difficult to cull: health spending is likely to be largely protected whoever wins the election, and welfare spending is going to increase as unemployment rises. However, some large capital spending projects are almost bound to be deferred or cancelled. There seems particular concern at CrossRail about a potential change of government. In addition, large energy projects seem vulnerable to delay, defence will come under scrutiny when operations in Afghanistan wind down, and prisons always suffer in this environment.

Conclusion

Some newspapers headlines recently might have led investors to fear that the UK’s budget deficit is about to lead to financial collapse. This is simply not true. Our total debt level is still lower than in many leading economies. But it is true that the annual deficit has recently ballooned in a way that will need large scale spending cuts and tax rises over the next decade to correct it.