At the time of the 2017 UK general election, then Prime Minister Theresa May spoke at various times during election debates about ‘there not being a magic money tree.’
This was in the face of high spending pledges made by the Labour Party, under Jeremy Corbyn, which included the abolition of student university fees and the nationalisation of railways and all the major utility companies.
The comment referenced the old adage that ‘money doesn’t grow on trees’, and implied that government spending pledges must be financed – usually by higher taxes and/or spending cuts in other areas.
The inference was that the Labour plans were unrealistic, and that the spending could never happen because the money would not be available.
Yet roll forward four years to today, and it does seem that there is indeed a ‘magic money tree’ in existence, and that it allows governments to spend vastly more than they receive in revenues – in the short term at least.
This ‘tree’, if that is the right word, has allowed the UK government to rack up an expected budget deficit of £355bn in this financial year (to March 2021), or 17% of GDP – massively higher than the deficit of £60bn in the year to March 2020, or 2.7% of GDP. Conveniently, the Bank of England has been buying most of this up through its Asset Purchase Facility.
The UK is also expected to run a deficit of £230bn in the year to March 2022. Thereafter, the deficit (the difference between government spending and taxes) is expected to fall gradually to £74bn, or 2.8% of GDP, in the year to March 2025.
At the Budget announcement of 3rd March, the Chancellor of the Exchequer did little to get the finances back in order. The furlough payments, and other government assistance including higher NHS spending and the vaccine rollout, which has cost a total of £352bn thus far, will remain in place until September.
The huge stimulus offered to the housing market, alongside rock bottom interest rates, also stays in place. The Stamp Duty holiday on house purchases up to a value of £500,000 remains till June, while a new 95% mortgage guarantee scheme for first time buyers has been introduced.
We even saw some new additional stimulus, such as the 130% ‘super-deduction’ on capital spending over the next two years, whereby companies can offset a large portion of their capex budgets against tax liabilities and which is expected to cost £25bn.
So, in other words the Treasury remains committed to keeping the economy ticking over – funded by increased debt – until the vaccines have been rolled out and COVID case rates have dropped significantly. Lockdowns can then be released, and the economy can go back to ‘normal’, with all the natural rebalancing of the deficit through increased tax revenues and the lower spending that this will entail.
Yet there were measures introduced by Rishi Sunak to get the government finances back in kilter over the long term. The rate of Corporation Tax will increase from the current 19% level to 25% in April 2023, a rise of six percentage points. This will reverse some of the reductions introduced by George Osborne in the previous decade, although ministers claim the UK will still have the lowest rate among G7 countries – assuming President Biden follows through with his pledge to increase corporate tax rates in the USA. Also, the rate will remain lower for smaller companies, and the government claims that only 10% of companies will pay the full higher rate.
Mr Sunak has also frozen tax thresholds for individuals, meaning that most people will slowly slip into higher tax brackets over time.
We heard much in the previous decade about ‘kicking the can down the road’, in terms of restoring the health of government finances after the Financial Crisis – deferring tax increases to later years by which time the economy has hopefully recovered – and this looks to be another instance of this.
As a result, the state of the government’s ‘balance sheet’ – the UK’s debt to GDP ratio – gets worse in the near term, reaching 110% of GDP in 2023/4, but starts improving after that as the economy continues to grow and debt as a proportion begins to decline.
But it is going to be fairly tight, and the truth is that the government’s finances are in the most precarious state they have been in in decades. Today’s spending largesse is only possible because the government’s interest rate cost is less than 2% of the size of the economy, and equally a relatively small proportion of government revenues.
Intriguingly, the initials for ‘magic money tree’ are the same as for an economic theory called Modern Monetary Theory (MMT), which states that, as long as governments can issue debt and print money in their own currency, there is no need to restrain deficits and debt, as long as the additional spending stimulates nominal GDP growth.
Assuming the real interest rate is lower than the real growth rate, the government can continue to run a deficit indefinitely, without getting into a ‘debt trap’.
On this basis, the increased debt should be manageable in the future, though it is likely to sit on the government’s books for a very long time indeed, with no prospect of a rapid paydown, and we will all be contributing more to it over time.
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