Jonathan Portes argues that the UK’s rising debt interest bill is not the reason why government spending is being squeezed while taxes rise – rather the UK’s fiscal problems are largely driven by tax and spending on public services.
Why are taxes going up (albeit slightly slower than previously planned after the Autumn Statement National Insurance cuts) while spending is being squeezed? The commentariat seem to have settled on an answer – it’s the UK’s rising debt interest bill, which at £116 billion this year is now frequently described as being the UK’s second largest item of spending, accompanied by this scary-looking chart from the Office for Budget Responsibility. Some gloomier economists have even begun describing the potential debt interest spiral as a ‘fiscal doom loop.’
This narrative suits everyone – fiscal hawks from the IFS to the Chancellor to the City, who’d like to use the rise in debt interest as a justification for further tax rises or spending cuts, those who want to blame a decade of Conservative mismanagement of the economy, which despite austerity has added a trillion pounds to the national debt, and those who claim that we need to ‘pay back’ the additional debt incurred during the pandemic as a result of the furlough and other government support schemes.
But the focus on the impact of debt and debt interest ignores, or at best oversimplifies in a misleading way, the basic arithmetic of government debt and the government’s own fiscal rules. It sounds obvious that the £116 billion (or 4% of GDP) that we are ‘spending’ on debt interest is money that would otherwise be available for public services or tax cuts. But that is simply wrong. Debt, and hence debt interest, is not the primary driver of our fiscal problems. Tax and spending (on public services) are.
Why? Because what matters for government debt is that it should be sustainable over the long term. And what does sustainable look like? The simplest, and by far the most commonly used, definition is that the debt/GDP ratio – that is, the ratio of government debt (what we owe) to national income (the tax base) should not be rising over time.
This forms the basis of the government’s own fiscal rule – that the debt to GDP ratio should be falling at the end of the forecast period. And the UK is entirely in line with international practice here – the debt/GDP ratio is the key ratio the IMF looks at, it is central to the EU’s debt and deficit rules, and so on. It’s certainly not the only thing that matters, and such rules are often criticised for not distinguishing between debt undertaken for current spending and for investment. But from a pure sustainability perspective the debt/GDP ratio is undoubtedly the obvious place to start.
So what do we need to do to stabilise the debt-GDP ratio? Well, suppose nominal GDP (that is, the cash value of GDP) is growing by 4% a year (which could be, for example, 2% real growth and 2% inflation). And suppose the interest rates we are paying on government debt is 4%. Then consider two examples.
- No debt in 2023. Spending at 40% of GDP and taxes at 40% of GDP. In this case, debt in 2024 will still be zero;
- Debt to GDP of 100% in 2023 (approximately the current level). Debt interest at 4% of GDP. Other spending at 40% of GDP, and taxes at 40% of GDP. In this case, debt in 2024 will be 104% of 2023 GDP. But 2024 GDP will be 104% of 2023 GDP as well. So the debt/GDP ratio remains at 100%.
In other words, even though we are ‘spending’ 4% of GDP “extra” on debt interest in a situation of 100% debt to GDP, we can ‘afford’ exactly the same amount of spending on public services as we could with no debt, and still stabilise the debt/GDP ratio. Intuitively, that’s because the debt interest bill, while it ‘adds to the debt’ in cash terms, isn’t really adding to the debt burden, relative to GDP – it’s just maintaining its real value. There’s no spiral, and certainly no ‘doom loop.’
We can formalise this with a very simple formula: the primary balance (PB), that is the government surplus/deficit before interest payments, must be equal to the debt (D) multiplied by the difference between the interest rate (r) and the nominal growth rate (g):
PB = (r-g)*D
How does that apply to the UK’s current position? Well, the OBR says that next year the difference between the interest rate and the nominal growth rate, which it calls the ’growth adjusted interest rate’, will be 0.5%.
Growth-corrected interest rate across the G7 countries
That means that the primary balance consistent with stabilising the debt is about 0.5% of GDP (since our debt is indeed close to 100% of GDP). So how much difference does our debt make?
Well, if we didn’t have any debt at all the above equation simplifies easily to PB=0. In other words, the extra tax/reduced spending we ‘need’ as the result of our debt ‘mountain’ isn’t £116 billion. It’s more like £13 billion. More than a rounding error – but not much more, and certainly not the main reason ‘high overall taxes and spending aren’t translating into high-quality public services’ – a claim which lets the government off the hook far too easily.
This rises by the end of the forecast period – when the government’s current fiscal rules bite, and the OBR’s forecast for the growth-adjusted interest rate rises to 1.4% – but is still closer to £35 billion (and even this requires some quite pessimistic assumptions about growth and interest rates, compared to the last 15 years, as the chart above shows).
So the UK’s fiscal problems are both better and worse than they look. Despite some of the commentary cited above, it’s not debt interest that forced the government to cut spending in the last Autumn Statement. Even if our debt was much lower – even if we hadn’t borrowed any more during Covid – the current fiscal rule would have been almost as difficult to meet.
The problem is, quite simply, we don’t pay enough tax to cover the cost of the services we want (and need). Of course, if debt was lower, we’d have more flexibility, and perhaps more room to manoeuvre when it comes to future crises – but the level of debt, and the interest we pay on it, is not the most important fiscal issue we face.
Does all this matter? Yes. On the one hand, it means that criticisms of some spending plans because they would add to the debt and the debt interest bill – like this bizarrely confused Daily Mail article, which argued that ‘Labour’s plan for £28 billion green investment would add £20 billion to the national debt’ – are often misplaced.
In fact, while such investment would add to debt, its implications for long-run sustainability are much smaller, according to both the government’s and the opposition’s own fiscal rules. On the other hand, it means we cannot blame the debt for the gap between the cost of the services the British public seem to want, and the taxes they seem prepared to pay.
By Professor Jonathan Portes, Senior Fellow, UK in a Changing Europe.