The benefits and costs of a deficit and of the national debt

Overview

Borrowing to build long-lived assets spread costs fairly across generations, tax smoothing and stock of government debt useful to the financial system.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why is it beneficial for a government to run a deficit during a downturn?

   Model answer

   In a downturn private spending falls, and if the government simultaneously cut its own spending to match its falling revenue, it would remove demand at the same moment as the private sector, deepening the contraction. Allowing the deficit to widen means the government continues to spend while taking less in tax, so the fall in total demand is smaller, fewer workers lose their jobs and fewer firms close. That matters beyond the immediate output loss, because prolonged unemployment erodes skills and attachment to the labour market, and firms that fail take their equipment, know-how and supplier relationships with them, so a deep recession reduces the economy's capacity permanently. Borrowing to prevent that is not merely a transfer of demand across time; it protects the productive base from damage that could not later be undone.

2. 2

   Why is borrowing to fund investment treated differently from borrowing to fund current spending?

   Model answer

   Borrowing to fund investment creates an asset on the other side of the liability. A road, a hospital or a power connection delivers services for decades and can raise the productivity of the private economy, so it generates a stream of benefits, and often of additional tax revenue, against which the borrowing can be set. Borrowing to fund current spending, such as wages or benefits, leaves nothing behind, so future taxpayers service a debt from which they receive no continuing benefit. This is the reasoning behind rules that permit borrowing only for capital purposes while requiring the current budget to balance over the cycle. The test is not perfect, since spending classified as current, on education and preventive health for example, can raise capacity as effectively as physical investment, and a badly chosen capital project can produce no return at all.

3. 3

   How does borrowing to build long-lived assets spread costs fairly across generations?

   Model answer

   A hospital built this year serves patients for fifty years, so its benefits accrue overwhelmingly to future citizens. Funding it entirely out of current taxation would mean that today's taxpayers paid the whole cost while receiving a small fraction of the benefit, which is neither fair nor likely to be politically sustainable, and it would probably mean the asset was never built. Financing it by issuing long-dated debt means the repayments are made over the period during which the asset is used, so each generation of taxpayers contributes roughly in proportion to the benefit it receives. The argument holds only for genuinely durable assets: applying it to current consumption reverses the fairness, because future taxpayers then pay for benefits enjoyed entirely by their predecessors.

4. 4

   What is meant by tax smoothing, and why is it an argument for borrowing?

   Model answer

   Tax smoothing is the idea that a government should keep tax rates relatively stable over time rather than moving them up and down with year-to-year changes in spending needs. The reason is that the distortion a tax causes rises more than proportionately with its rate, so alternating between very high and very low rates does more damage to incentives than a steady middling rate raising the same total revenue. It also creates uncertainty that discourages investment and long-term decisions. When an unusual and temporary demand on the public finances arises, such as a war or an emergency, borrowing allows the cost to be spread over many years at a stable tax rate, which is less damaging than a sharp temporary increase in rates and then a reduction.

5. 5

   Why is a stock of government debt useful to the financial system?

   Model answer

   Government bonds are the closest thing to a risk-free asset denominated in the domestic currency, and several parts of the financial system need such assets to function. Pension funds and life insurers have obligations extending decades ahead and must hold long-dated, safe assets to match them. Banks are required to hold liquid assets against the possibility of withdrawals, and government bonds are the standard qualifying asset. Their yields provide the benchmark against which every other asset is priced, so a deep and liquid government bond market improves pricing throughout the financial system, and they serve as the collateral in which a great deal of short-term lending is secured. A country with no government debt at all would have to find substitutes for all of these functions.

6. 6

   Why is the debt interest bill described as an opportunity cost, and how large can it become?

   Model answer

   Interest must be paid before anything else, and the money buys no service: it is a transfer to bondholders, so every pound of it is a pound not available for health, education, defence or tax reduction, which is the opportunity cost. It also has a distributional dimension, since it is financed by taxpayers generally and received by holders of financial assets, who are on average wealthier. Its scale can be substantial: a debt of £2,000 billion at an average rate of 2% costs £40 billion a year, and if refinancing at 4% doubles that to £80 billion, the increase alone exceeds the budget of many departments. Because the bill grows with both the stock of debt and the rate of interest, a country can find that a rising share of its taxation is committed before any spending decision is made.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.