A simple guide to the UK fiscal deficit

Confused about the government’s deficit? Are we most of the way there, as the Prime Minister has claimed, or is there rather more to find, as the IFS suggest? And what is 'there' anyway - what are we aiming for exactly?

The first way to make things intelligible is to express everything as a percentage of annual GDP. So if you see a figure in £ billion, just divide by something a bit larger than 17 to get it as a percentage of annual GDP. (UK GDP in 2013 was £1713 billion.)

The second thing to get clear is what the reference point should be. When is a deficit too big? The answer that some would like to suggest is that any deficit is too large, and that we should aim to eliminate the deficit completely. However for economists a more natural reference point given our current position is to ask what level of deficit would keep the ratio of government debt to GDP stable. Public sector net debt, which is the definition the OBR tends to use, is approaching 80% of annual GDP. If the economy grew by 4% in nominal terms each year, then a deficit (‘public sector net borrowing’) of 3.2% of GDP would keep the debt to GDP ratio stable at 80%. (0.04 x 80% = 3.2%.)

How does that compare with where we are now? The most relevant figure here is the cyclically adjusted deficit excluding Royal Mail and APF transfers, which the OBR estimated in March was 5% of GDP for financial year 2013/4. [1] That was the OBR’s best guess at what the deficit would have been in 2013/14 if the economy was on track, with a zero output gap.

That is looking at the position in the recent past. Of course the government already has policies designed to make additional future savings, so to factor these in we need to look at where the OBR expects us to be in the first year of a new government, which will be financial year 2015/16. In March it expected a cyclically adjusted deficit excluding transfers of 3.4% of GDP for that year. In other words, the government will have just about got us to a position where the debt to GDP ratio is no longer rising, if it implements planned savings and everything pans out as the OBR expects. As a result, the OBR suggests 2015/16 will be the year debt/GDP peaks.

That means a lot of ‘progress’ has been made compared to a peak actual deficit of just over 10% of GDP in 2009/10. [2] I personally would not call it progress, because I would have increased the deficit in 2010 to help end the recession more quickly, but this post is just about trying to make sense of the numbers.

The fact that by 2015/16 we will have roughly stabilised the debt to GDP ratio might surprise many people (but not all, as this poll discussed by the FT indicates). Are not the papers full of all the additional austerity there is still to come after the next election? One reason they suggest that is that all political parties are not content to just keep the debt to GDP ratio constant at 80%. They think this number is too large for the long term health of the economy, and there are a number of reasons why they may be right, which I discuss with Jonathan Portes here. But the speed at which debt is reduced is a choice - one that I have discussed here, here and here - and not some imperative that must be done or something terrible will happen.

One final point to note. I have talked about the deficit above, which includes public sector investment. Figures are often quoted for the current budget, which excludes this investment. So, for example, while the Chancellor plans to eliminate the total deficit by 2018/19, Labour intends to achieve only a zero current balance, and has left open the possibility that its target might not be achieved until 2020. Currently investment is around 1.5% of GDP, so just add this to any current balance deficit to get a rough idea of what the implied total deficit would be. So if we start from a cyclically adjusted deficit of 3.4% in 2015/16, the Conservatives aim to get this down to zero in 2018/9, but Labour only aim to reduce it to around 1.5%, possibly at a later date. That implies much less austerity under Labour’s plans, even if we make no allowance for additional Conservative cuts to finance the tax breaks Cameron announced. For a much more detailed analysis, which comes to similar conclusions, see this from the Resolution foundation.

If that also comes as a surprise, because you had read that all parties would have to undertake painful austerity, it is because Labour seem quite happy to give that impression. Having argued in 2010 that the Conservative plans were too far, too fast, and lost that election (and according to mediamacro, lost the argument more generally), they do not want to fight on that territory again. The aim of this post is to help distinguish important real fiscal choices from the spin that often surrounds them.

 

[1] The OBR expected in March that the ‘headline’ deficit for financial year 2013/14 would be 5.8% of GDP. However this figure is flattered by some one-off (Royal Mail and APF) transfers, and so a more meaningful number excludes these, which is 6.6% of GDP. The OBR estimate that 1.6% of that 6.6% is simply the result of the currently depressed economy.

[2] The OBR estimate that about a fifth of that deficit was a temporary result of the recession, so they estimate a cyclically adjusted deficit of 8% that year, which is the more relevant benchmark if you want to think about the proportion of austerity we have already had compared to what might be still to come.