Do taxes need to rise, or public spending be cut, to pay for the Covid-19 crisis? With government spending having caused a huge increase in public debt – now already over 100 per cent of national income – the argument on how and when it should be paid back is already raging.
The government has been quick to deny that it has plans to return to “austerity”. But it has been noticeably more reticent on tax rises. And the outriders are already making the case. Last week former chief secretary to the Treasury David Gauke declared that, “to reassure the markets of his fiscal credibility”, Chancellor Rishi Sunak should set out a “tax raising strategy” in the autumn budget.
As some have noted, this line appeared to be echoed in the latest report of the official government watchdog, the Office for Budget Responsibility. "In almost any conceivable world,” it said, “there would be a need at some point to raise tax revenues and/or reduce spending (as a share of national income) to put the public finances on a sustainable path."
But hold on. The OBR is not saying that taxes have to rise any time soon. This passage is a response to a chart which shows public expenditure and tax revenues out to 2070, in which the huge increase in public debt (to between 300 per cent and 500 per cent of national income) is the result not of current Covid-related expenditure but long-term demographic trends. As it has for many years, the OBR is pointing to the fact that over the coming decades a dramatic increase in the number of elderly people will be accompanied by a reduction in the working age population. Unless something changes, governments will simply not have enough tax revenue to pay for hugely increased health, social care and pension requirements.
So it is vital to separate out two different arguments. In the medium to long term, taxes do need to rise. This is nothing to do with coronavirus, but the consequence of an ageing population, and the need for better quality public services. Our tax system at present simply doesn’t raise enough money.
But in the short term, tax rises would be disastrous. Unless levied exclusively on the very rich – for which some of the very rich are now calling – this would withdraw demand from the economy just when it needs stimulating. It is a fundamental principle of macroeconomics – as Keynes demonstrated many years ago, and as the experience of austerity after the financial crisis proved – that when the economy goes into recession, and unemployment rises, you need sustained government spending and deficits to raise demand and get the economy moving. Tax revenues will then rise, leading deficits and debt to fall. Spending cuts and tax rises do precisely the reverse. We are now in the deepest recession for 300 years.
But how then should we pay for the current increase in government spending? The answer is – slowly. There is wide agreement among macroeconomists about this. There are two reasons why.
First, interest rates are at rock bottom. What matters to future taxpayers is not the ratio of debt to GDP itself, but the cost of servicing that debt. Remarkably, when inflation is taken into account, the government can now borrow at negative rates for 20 years ahead. This makes servicing current debt, even at levels more than 100 per cent of national income, much cheaper than when the debt pile was much smaller. Indeed, as long as interest rates are below the growth rate of the economy, economic growth will gradually cause debt as a proportion of national income to decline. Very few economists expect interest rates to rise significantly for many years.
Second, the Bank of England can always buy government debt. It has been doing so vigorously since the crisis hit, as it did after the financial crash in 2008. This is one reason that interest rates are projected to stay low. The prevailing assumption behind quantitative easing has been that at some point in the future the Bank of England will sell the debt back to the private sector. But no such “unwinding” has yet occurred, and there is no necessity that it should. Central banks can hold government debt indefinitely, if necessary. So long as today’s low inflationary expectations persist, there is no reason why they should not do so.
So there is no need for governments to seek to pay back their newly-raised debts in a short period of time, whether through tax rises or spending cuts. We can acknowledge that the crisis has caused a necessary increase in debt, and accept that this will be reduced over a long period. This will be the “new normal” of macroeconomic policy.
Or more accurately, it will be a return to an old normal. For bringing debt down slowly is what has happened before. During and after the Second World War, national debt was much higher even than today’s forecasts, rising to a peak of 270 per cent of national income as the government paid for the war effort. So far from there being a return to austerity, the immediate postwar period saw an expansion of public expenditure on health, housing and welfare services. These contributed to growth, as well as to a reduction in inequalities (which also contributed to growth), and there was almost no demand for the debt to be repaid quickly. It took 30 years for UK public debt to return to 50 per cent of GDP. The Bank of England bought up significant portions of the new debt and held it on its own balance sheet.
After the financial crash we were told that the national economy is like a household: it must live within its means, and pay back its debts. But the metaphor was wrong then, and it is even less applicable today. Today the appropriate metaphor is that the coronavirus crisis is like a war. In wartime governments spend what it takes to defeat the enemy, and borrow from their central banks to do so. They then pay the debt back over a long period, relying on investment and growth (and some inflation).
Today we must do the same. For it is not just a war against Covid that we face today. We also face a climate and environmental emergency. This demands much higher levels of investment than the government has yet announced – in low-carbon infrastructure, industrial transformation and nature restoration. It would be quite wrong to hesitate because of anxiety about the need to pay back government debt.
Michael Jacobs is a professorial fellow at the Sheffield Political Economy Research Institute at the University of Sheffield
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