How should the government meet its Golden Rule when debt interest increases?

 

As you are almost certainly aware, the government is having to pay much more in interest on its debt than it used to do. Here is a chart based on the last OBR forecast, and the likelihood is that their next forecast will revise these numbers upwards. An increase worth 2% of GDP may not sound big, but it is nearly as much as the current defence budget.

Should this additional spending on debt interest be matched by higher taxes or reduced spending elsewhere? It has to be one or the other to meet the government’s sensible fiscal rule, sometimes called the golden rule, which matches current spending (i.e. excluding public investment) to total taxes. In my post about rising interest rates two weeks ago, I gave my opinion that the government should raise taxes, but not the reasoning behind it.

To many the issue is simply political. Right wing governments would choose lower public spending and more left wing governments would choose to raise taxes. If you look at past trends in UK public spending it is normally obvious which government was in power, but not always. The chart below looks at the ratio of all government consumption except health spending divided by private consumption. My reason for choosing this ratio will become clear.

Government consumption differs from total public spending because it excludes debt interest payments, government investment but also transfer payments (e.g. state pension payments). In the UK and pretty well every other country health spending is strongly trended upwards for well known reasons, which is why I have excluded it from government consumption in the chart above. While the austerity period is obvious from the chart, the Johnson administration did start to raise spending in some areas. [1]

The breakdown of government consumption over time, again as a ratio to private consumption, is shown here.

‘Soc prot’ stands for social protection (e.g. spending on care homes, foster care, social benefit or the salaries of those administering the welfare system), and other spending is split between central and local government. Note the rise in spending on education under the last Labour government, and the sharp cuts in other local authority spending during the austerity period.

Why have I looked at the ratio of public consumption to private consumption? As an economist, it seems to me that private consumption is the natural comparator when thinking about public spending on goods and services. If the state did not provide schools, for example, then all spending on schools would be part of private consumption, and its ratio to total consumption would represent the aggregate choice of consumers. In other words, consumers have preferences over public goods as well as private goods, and it is the government’s job to satisfy those preferences given the tax constraint.

For this reason I don’t think saying the level of public spending is just a political decision is good enough. To put it very simply, governments should provide roughly the amount of, say, education spending that the private sector would choose if these were not public goods. It could be the case that left leaning voters prefer more public goods than right leaning voters, but I’m not sure this is the case (apart from those who opt out of the public system, of course). Indeed one group that you might expect to want much higher health spending because they use these services more are the old, who tend in the UK to vote for the right.

There are real political differences over what services the state should provide, and under Thatcher there was a big reduction in the scope of the state with privatisation. (Even there, however, I think economics has more interesting things to say than the platitudes of politicians.) One of the problems of austerity from 2010 onwards is that public spending was cut with hardly any reduction in the kind of services the state was meant to provide, so the effect was just poorer quality services, rising waiting times and so on. [2]

Which brings us back to the title of the post. Here a household analogy is useful (they can be sometimes). Imagine there was no state beyond an army, and a household’s mortgage payments had increased because of higher interest rates. They needed to find that money from somewhere. Would they cut back on the children’s education, not go to the doctor so often when they are ill, and maybe reduce their help to a disabled elderly relative, but otherwise keep their other spending, including meals out and entertainment, unchanged? I hope not. But that is exactly what anyone saying higher that public spending should be cut back as a result of higher interest rates is in effect suggesting.

A more reasonable approach for a household would be to cut back on all its items of expenditure evenly, or maybe cut spending on luxuries more than necessities. That is why I would suggest, in the first instance, raising taxes to cover the additional debt interest. Higher taxes will lead to lower consumption spending, mimicking what the household would do in the face of higher interest rates.

In effect that is what the government has been doing over the last few years, which is a key reason why taxes have been increasing and are expected to carry on rising. Now if consumption does fall [3], then by the same logic public spending should fall in proportion, but that is public spending falling in line with GDP, rather than taking all the burden of adjustment. Crucially higher debt interest payments should mean higher taxes in the first instance.

That is the economic logic behind my view that higher debt interest payments that are expected to be persistently high should be mostly covered by higher taxes rather than spending cuts. Those who suggest otherwise have to argue why only certain goods and services that consumers benefit from should bear all the burden of paying for the higher cost of debt.

The same logic makes me question the idea that economic growth somehow in itself reduces fiscal pressures, It appears to do so because spending plans are fixed over the next few years in nominal or real terms, but taxes rise when GDP increases. But to the extent this happens it reduces the share of public spending in GDP, which if the previous share was near optimal will lead to pressure to raise spending in due course (mainly be increasing public sector wages or employment). I think the real reason growth eases fiscal pressures is that it allows politicians to raise taxes while still allowing some growth in living standards..

[1] The same chart based on nominal spending shows a similar shape, but has a more upward trend, presumably because productivity gains have been lower for public services than for the goods and services that make up aggregate private consumption.

[2] The other way the Conservative government cut public spending was to reduce the relative pay of public sector workers, which unsurprisingly turned out to be unsustainable.

[3] Higher debt interest payments in themselves will tend to raise consumption, because consumers directly or indirectly hold government debt. However higher interest rates discourage consumption and encourage saving. These are what economists call income and substitution effects.