4.5.3 Public Sector Finances Flashcards
What is the distinction between automatic stabilises and discretionary fiscal policy?
Automatic stabilisers are automatic fiscal changes as the economy moves through stages of the business cycle – e.g. a fall in tax revenues from the circular flow during a recession or an increase in state welfare benefits when unemployment is rising. Explanations for automatic stabilisers:
- Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending.
- Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits.
- Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit During a recession, revenue is likely to be lower due to less income earned, less profits made and fewer goods being bought and at the same time government expenditure on transfer payments e.g. income support and unemployment benefit.
Discretionary Fiscal Policy
This refers to deliberate changes in government spending and taxation made by policymakers in response to economic conditions. Unlike automatic stabilisers, these policies require government decisions and legislative approval. They are used to actively manage aggregate demand (AD) to influence economic growth, inflation, and employment. E.g. tax cuts or infrastructure spending
What is the distinction between a fiscal deficit and the national debt?
Fiscal deficit
A government’s fiscal (or budget) deficit is the difference between its spending and income from taxes and other revenues. A “large deficit” implies that state sector spending substantially exceeds tax revenues in a given year.
National Debt
The national debt is the total amount of money that a country owes to its creditors. It is calculated by adding up all of the government’s outstanding debt, including bonds, notes, and bills.
The national debt can be a significant burden on a country’s economy. When a country borrows money, it has to pay interest on the loan. This interest can add up over time, and it can make it difficult for the country to repay its debt.
The national debt can also affect a country’s credit rating. A high national debt can make it more difficult for a country to borrow money in the future. It represents the total amount of money owed by the government to domestic and foreign lenders.
It is a stock concept, meaning it is measured at a specific point in time.
Example (UK 2024):
The UK’s national debt surpassed £2.7 trillion
What is the distinction between structural and cyclical deficits?
1. Structural Deficit
- A structural deficit occurs when a government’s spending exceeds its revenue even when the economy is operating at full capacity (long-run trend level of GDP).
- This type of deficit is independent of the economic cycle and reflects underlying imbalances in public finances, such as excessive government spending or insufficient tax revenue.
- Structural deficits often require policy changes (e.g., tax increases or spending cuts) to correct.
- E.g. The UK had a persistent structural deficit following the 2008 financial crisis, meaning that even when the economy started recovering, the government still spent more than it collected in taxes due to high welfare costs and lower productivity growth.
2. Cyclical Deficit
- A cyclical deficit occurs due to the business cycle, meaning it arises during periods of economic downturn or recession when tax revenues fall and government spending (e.g., welfare payments) increases.
- It is temporary and should shrink as the economy recovers.
- Cyclical deficits occur because of automatic stabilisers like progressive taxation and unemployment benefits.
- E.g. During 2020-21, the UK ran a large cyclical deficit as GDP shrank due to lockdowns.
- Tax revenues fell due to lower income and corporate profits, while government spending soared due to furlough schemes and welfare payments.
What factors influence the size of a fiscal deficit?
These factors can be cyclical (temporary) or structural (long-term).
1. Economic Growth Rate
- Higher economic growth → Smaller deficit: More people are employed, businesses are profitable, and tax revenues (income tax, VAT, corporation tax) rise. At the same time, welfare spending (e.g., unemployment benefits) falls.
- Lower economic growth / recession → Larger deficit: Tax revenues decline, and government spending on welfare rises.
- Example (UK 2020): During the COVID-19 recession, GDP contracted, reducing tax revenues and increasing government spending on furlough schemes, worsening the fiscal deficit.
2. Level of Government Spending (Expenditure)
- Expansionary fiscal policies (e.g., increased spending on infrastructure, welfare, or defense) increase the deficit.
- Austerity measures (spending cuts) reduce the deficit.
- Example (UK 2010-2015): The UK government implemented austerity policies, cutting public sector spending to reduce the large deficit after the 2008 financial crisis.
3. Tax Revenue (Taxation Policy & Compliance)
- Higher tax rates and stronger enforcement reduce the deficit.
- Tax cuts (e.g., lowering income tax or corporation tax) can increase the deficit unless they boost growth enough to offset revenue loss.
- Tax avoidance and evasion reduce government revenue, increasing the deficit.
- Example (UK 2023): The increase in corporation tax from 19% to 25% was aimed at raising revenue to help reduce the fiscal deficit.
4. Interest Rates on Government Debt
- If the government has a high level of debt, higher interest rates mean more spending on debt repayments, worsening the deficit.
- If interest rates are low, borrowing is cheaper, making deficits easier to manage.
- Example (UK 2022-23): Rising Bank of England interest rates increased government debt interest payments, adding pressure to the deficit.
5. Demographics and Ageing Population
- An ageing population increases spending on pensions, healthcare, and social care, worsening the fiscal deficit.
- A declining working-age population can reduce tax revenues, making it harder to balance the budget.
- Example (UK): The state pension age has been gradually rising to reduce the burden on public finances as life expectancy increases.
6. External Shocks (e.g., Wars, Pandemics, Energy Crises)
- Events like wars, pandemics, or financial crises lead to emergency government spending and reduced tax revenues, worsening the deficit.
- Example (UK 2022-23): The UK government introduced the Energy Price Guarantee to help households with soaring energy bills after the Russia-Ukraine war, increasing the deficit.
7. Exchange Rates and Trade Deficit
- If the UK imports more than it exports, it may collect less tax revenue from businesses, affecting the deficit.
- A weaker pound makes imports more expensive, raising costs for the government if it buys goods/services from abroad.
- Example (UK Post-Brexit): Trade disruptions and a weaker pound increased import costs, impacting tax revenues and government spending.
What factors influence the size of national debt?
1. Government Borrowing (Fiscal Deficits and Surpluses)
- If a government runs persistent fiscal deficits (spending exceeds revenue), it must borrow to finance the gap, increasing national debt.
- If it runs a surplus (spending is less than revenue), it can reduce debt.
- e.g. The UK government borrowed £100 billion in 2023-24 to cover its budget deficit, increasing national debt.
2. Economic Growth
- Higher GDP growth increases tax revenues (more income tax, VAT, and corporate tax), reducing the need for borrowing and making existing debt more manageable.
- Slow or negative growth (e.g., during recessions) reduces tax revenue, increasing borrowing and debt.
- e.g. Post-2008 recession, UK debt rose sharply as GDP stagnated and tax revenues fell.
3. Interest Rates on Government Debt
- If interest rates on government bonds are low, borrowing is cheaper, making it easier to sustain higher debt levels.
- If rates rise, debt repayments become more expensive, increasing the burden.
- e.g. The UK benefited from historically low interest rates post-2008, but rising rates in 2023 increased debt servicing costs.
4. Inflation
- Moderate inflation reduces the real value of debt, making it easier to repay.
- High inflation can also push up interest rates, making borrowing more expensive.
- e.g. The UK’s inflation surge in 2022-23 increased interest payments on inflation-linked government bonds.
5. Demographics (Ageing Population & Welfare Costs)
- An ageing population increases spending on pensions and healthcare, leading to higher borrowing and national debt.
- A shrinking workforce reduces tax revenues, worsening the debt situation.
- e.g. Rising pension and NHS costs due to an ageing population have put pressure on UK public finances.
6. Public Spending Commitments
- High government spending on welfare, healthcare, and infrastructure can increase national debt if not matched by revenue.
- Austerity (spending cuts) can slow debt accumulation but may hurt growth.
- e.g. Post-2010, the UK implemented austerity policies to control debt, cutting public services and welfare spending.
7. Taxation Policy
- Higher taxes can reduce debt by increasing government revenue.
- Tax cuts (without equivalent spending cuts) can increase borrowing and debt.
- e.g. The UK raised corporation tax from 19% to 25% in 2023 to boost revenue and reduce borrowing.
8. External Shocks & Crises
- Events like pandemics, wars, and financial crises force governments to borrow heavily to support the economy.
- e.g. UK national debt exceeded £2.5 trillion due to borrowing for furlough schemes and business support in 2020-21.
What is the significance of the size of fiscal deficits
1. Impact on National Debt
- A large and persistent fiscal deficit increases national debt because the government must borrow to cover the shortfall.
- This can lead to higher debt interest payments, reducing funds available for public services.
- The UK’s national debt exceeded £2.7 trillion in 2024, partly due to years of fiscal deficits.
2. Economic Growth and Aggregate Demand (AD)
- A fiscal deficit, if used for productive government spending (e.g., infrastructure, education), can boost economic growth by increasing AD and investment.
- However, excessive borrowing may crowd out private sector investment if it leads to higher interest rates.
- The UK’s fiscal deficit during COVID-19 stimulated demand but also increased long-term debt.
3. Inflationary Pressures
- If a fiscal deficit is financed by borrowing rather than tax increases, it injects more money into the economy, potentially leading to demand-pull inflation.
- If deficits persist in a high-inflation environment, it may force the central bank to raise interest rates, slowing growth.
- The UK’s £45bn tax-cut plan under Liz Truss in 2022 led to concerns about inflation and fiscal sustainability, causing market turmoil.
4. Investor and Market Confidence
- Large fiscal deficits may worry financial markets, leading to higher borrowing costs for the government.
- If investors lose confidence in a country’s ability to repay debt, bond yields rise, making borrowing more expensive.
- After the 2022 mini-budget, UK gilt yields spiked, forcing government intervention to stabilise markets.
5. Taxation and Future Policy Adjustments
- Persistent fiscal deficits may force the government to raise taxes in the future to finance debt repayments.
- This can reduce disposable incomes and slow economic growth.
- In 2023, the UK raised corporation tax from 19% to 25% partly to reduce fiscal deficits.
6. External Borrowing and Exchange Rates
- If deficits are financed by borrowing from abroad, the UK becomes reliant on foreign lenders, increasing external debt risks.
- Large deficits may lead to a weaker pound (£) if investors lose confidence in UK finances.
- The pound fell sharply after the 2022 mini-budget, reflecting market fears over unsustainable borrowing.
Final Evaluation: Does the Size of the Fiscal Deficit Matter?
- Short-Term: Large fiscal deficits can stimulate growth and support the economy during recessions.
- Long-Term: Persistent deficits can increase national debt, inflation, and borrowing costs, limiting future policy flexibility.
What is the significance of the size of the national debt
1. Debt Sustainability & Interest Payments
- A high national debt means the government must spend more on debt interest payments, reducing funds available for public services like healthcare and education.
- If interest rates rise, debt servicing costs increase, worsening the fiscal situation.
- The UK’s debt exceeded £2.7 trillion, and rising interest rates meant debt interest payments hit £100bn annually, making it harder to fund public services.
2. Impact on Future Taxation & Public Spending
- High debt may force governments to raise taxes or cut spending to manage repayments, potentially slowing economic growth.
- If debt is used to fund productive investment (e.g., infrastructure), it can boost future growth and tax revenues, reducing debt in the long term.
- Post-2010, the UK adopted austerity policies (spending cuts and tax increases) to reduce debt, affecting public services and economic growth.
3. Intergenerational Burden
- Large debt today may place a burden on future generations, who will have to repay it through higher taxes or reduced government services.
- However, if debt is used for long-term investment (e.g., transport, education), future generations may benefit.
- Borrowing for HS2 and renewable energy projects could provide future economic benefits despite increasing debt.
4. Crowding Out Effect
- If the government borrows heavily, it may push up interest rates, making borrowing more expensive for private firms.
- This reduces private investment, slowing growth (crowding out).
- In the 1980s, high government borrowing contributed to high interest rates, discouraging private sector investment.
5. Confidence in the Economy & Credit Ratings
- If debt becomes too large, investors may lose confidence in the government’s ability to repay, causing higher borrowing costs.
- Credit rating agencies may downgrade a country’s credit rating, making future borrowing more expensive.
- The UK lost its AAA credit rating due to concerns about high debt levels, leading to higher borrowing costs.
6. Inflation & Money Supply
- High debt may lead to inflation if the government prints money to finance it (monetary financing).
- However, moderate inflation can reduce the real burden of debt, making repayments easier.
- High inflation increased the cost of servicing inflation-linked bonds, worsening the UK’s debt situation.
7. Debt-to-GDP Ratio & Economic Growth
- The size of the national debt is most important relative to GDP (debt-to-GDP ratio).
- A high ratio (e.g., over 100%) may indicate risk, but if GDP grows faster than debt, the burden reduces.
- UK debt-to-GDP ratio rose above 100%, raising concerns about long-term sustainability.
