Unit 4 Macro: Economics of Fiscal Deficit Reduction

How far, how fast and in what way should the UK government seek to cut the annual budget deficit and improve the state of public sector finances? These questions continue to be at the centre of a fierce debate among economists.

Two key aims of the Coalition government in this area are:
• To accelerate the reduction of the structural budget deficit over the course of a Parliament

• The main burden of deficit reduction is from reduced spending rather than increased taxes

The case for cutting the budget deficit quickly

1. Credit rating: High and rising debt threatens the UK’s financial stability and the AAA credit rating. Losing the rating would increase borrowing costs, choking off the recovery

2. Limit future tax rises: Higher public sector debt will eventually lead to a rise in the tax burden for businesses and consumers. The Institute of Fiscal Studies (IFS) has estimated that that to reduce the UK budget deficit over the next five years will require every person in the UK to pay over £1250 of extra taxes each year.

3. Avoid crowding out: Putting points 1 and 2 together, if borrowing stays high, increased interest rates and taxes risk crowding-out spending and investment by the private sector

4. Fairness: It is inequitable to leave future generations with excessive levels of debt to repay, today’s tax payers need to make a bigger contribution to the cost of state spending. Higher public sector debt represents a transfer of income from those who pay taxes to people who hold government debt and causes a redistribution of income and wealth in the economy

5. Emphasis on monetary policy: There are doubts about the size of the fiscal multiplier and effectiveness of fiscal stimulus policies. If the government cuts spending and borrowing, this will give the Monetary Policy Committee more freedom to continue using low interest rates and other techniques such as quantitative easing (QE) to promote growth and recovery

Naturally there are plenty of opponents to the Osborne approach to fiscal deficit reduction. Many of approach the issue from a Keynesian perspective and they argue that there is a strong case for the government allowing higher levels of public sector borrowing especially when private sector confidence and demand is weak because of domestic and global uncertainty.

Arguments against fiscal austerity – the case for higher government borrowing

1. Government borrowing can benefit growth:
a. A budget deficit can have positive effects if it is used to finance capital spending that leads to an increase in the stock of national assets. For example, spending on transport infrastructure improves the supply-side capacity of the economy.

b. Increased investment in health and education boosts productivity and employment

2. Demand management: Keynesian economists support the use of changing the level of government borrowing as an instrument of managing aggregate demand.

a. An increase in borrowing is a vital stimulus to demand when other sectors of the economy are suffering from weak or falling spending. Fiscal policy can play an important counter-cyclical role “leaning against the wind” of the economic cycle

b. Deep cuts in government spending risks de-railing a fragile recovery

c. A second recession will actually make the fiscal deficit worse

3. Bond interest rates are low – there is a strong demand for UK bonds (gilts) and the UK government can currently borrow at low interest rates. It makes sense to take advantage of this now and boost government spending in key areas to kick-start a weak economy.

4. Fiscal multipliers: If the multiplier effect of higher spending or tax cuts is high, a fiscal stimulus might be self-financing because it will generate higher incomes, more jobs and extra tax revenues. Equally deep cuts in spending will create negative multplier effects costing many thousands of jobs in the private sector too

5. Targeted and temporary tax cuts: Instead of cutting government spending, Osborne should change course and allow tax cuts to boost demand. Shadow Chancellor Ed Balls has been calling for reductions in the rate of VAT from the current level of 20% and also reductions in employer national insurance contributions in a bid to expand employment particularly among the long-term unemployed.