Yael Selfin, Chief Economist in the UK considers the relationship between higher taxes and public finances for greater sustainability.
COVID-19 crisis hits public finances this year
A weak economy that will see a smaller take in government revenue and costly temporary measures to support the economy are to increase the deficit significantly in this fiscal year. Estimates based on government’s spending announcements so far suggest that public sector borrowing could climb as high as 16% of GDP in FY2020-21. That figure could be even higher if the government provides extra support for vulnerable parts of the economy – such as businesses affected by the restrictions announced yesterday – as well as extra funding to combat the pandemic. For example, if the government’s ‘moonshot’ testing plan goes ahead, with a cost of £100bn, the deficit would rise to almost 21% of GDP this fiscal year.
This may not be too alarming if a COVID-19 vaccine is approved early next year. Low interest rates and a large quantitative easing programme by the Bank of England could help absorb the extra debt. We expect an early vaccine will boost growth and mean that the deficit could fall to 6% of GDP in 2021-22. Any economic recovery will drive a rise in tax revenues while temporary support policies are gradually withdrawn. In such a scenario, public finances should improve before any potential increases in taxes, but probably not sufficiently.
The government may have to raise taxes to bring public finances under control
Overall public sector spending looks likely to top 51% of GDP this year, compared to 40% before the COVID-19 recession started. As economic activity recovers and temporary measures to fight the recession are withdrawn, public spending is expected to fall gradually back to 43% of GDP by FY2024-25. It will still be short of revenues, though, which are expected to amount to only 38% of GDP by that fiscal year, leaving a deficit of 5% of GDP.
The government may need to raise taxes before the end of the current parliament to bring public finances under control as, unlike the aftermath of the great recession, the scope for spending cuts is much lower. Spending took the main burden of adjustment in the aftermath of the Great Recession of 2008-09, falling from 46% of GDP in FY2008-09, to less than 40% of GDP in FY2018-19. As the government protected some areas, such as health, this meant unprotected areas were exposed to severe budget cuts. For example, the size of central government grants to local authorities fell by an estimated 49.1% in real terms between 2010–11 and 2017–18, while Her Majesty’s Courts and Tribunal Service saw an 18% reduction in spending by 2018-19. A return to austerity may not now be feasible, and although taxes are likely to rise, the current low interest rate environment reduces the costs of servicing public debt, helping to lower the extent of tax rises required.
With debt expected to reach 105% of GDP by FY2021-22, the government is likely to want to lower that ratio once the economy begins to recover. That means that it will need to run a deficit of less than 3%, representing the increasing size of the economy in nominal terms. The government is likely to have a shortfall of over two percentage points of GDP that it will have to plug through tax rises, worth over £50 billion.
There are many permutations of tax changes that the government could opt for. To raise around £50 billion, it could combine an increase of all rates of income taxes by 2p, with a two percentage point rise in corporate tax and VAT, as well as a one percentage point increase in National Insurance contributions.
It is quite likely that taxes will need to rise higher still. Once the pandemic is out of the way, the government has a long list of areas it wishes to focus on. These include its levelling-up agenda, investing in digital infrastructure and protecting the environment. All will stretch public finances further. These ambitious plans also mean that the state is set to take a bigger role in the economy than it has in recent times.
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