The source of the deficit

There are innumerable claims from the Coalition government and its supporters that the source of the public sector deficit is Labour’s over-spending. But one graph, on the Treasury’s own website, demonstrates that assertion is untrue.

There are innumerable claims from the Coalition government and its supporters that the source of the public sector deficit is Labour’s over-spending. But one graph, on the Treasury’s own website, demonstrates that assertion is untrue. Scrolling down to the bottom of the screen reveals a chart showing public outlays and public sector incomes since FY1998/99 and the difference between the two; the level of public sector net borrowing.

What the chart shows is a widening in the deficit in FY 2008/09, which coincided precisely with the onset of the recession in Q2 2008. The deficit is a recession effect.

There are two direct recession effects on government finances. For economies with some degree of social safety net spending rises automatically as more people require welfare. For all economies with a tax regime, tax revenues decline as activity falls. In this particular case, public sector current expenditure rose by £15.4bn (June 2010 Budget Redbook, Table C16).

This is a modest rise of 2.8%. At the same time public sector current receipts fell by exactly the same amount, £15.4bn (Treasury Databank, C4, http://www.hm-treasury.gov.uk/psf_statistics.htm). They fell further again in the last FY, for a cumulative fall of £34.6bn over the 2-year period.

But, as we see from the chart, prior to the recession both revenues and outlays were rising as the economy expanded. From the time when Labour was elected in 1997 to the recession at the beginning of 2008, public sector current receipts rose by an annual average 6% (Databank, C1). But the trend growth in government spending over that period was 5.5% (Databank, B1).

To extrapolate, if the recession had not occurred and those trends had been maintained, spending would have been £597.5bn in the last FY. Instead, the outturn was £600.6bn, just £3.1bn higher. On the same trend basis, current receipts would have been £617.1bn.

But the outturn in the last FY was £514.6bn, a shortfall of £102.5bn. This is 66% of the entire public sector borrowing requirement of £154.7bn, while the increase in spending above trend is just 2%. The deficit is overwhelmingly attributable to plunging taxation receipts. (In the chart, the cost of the bank bail-out is included in public secto rborrowing- this is the other major source of the deficit.)

One of the Coalition’s arguments is that the Labour governments allowed spending to rise above taxation receipts over a prolonged period, well before the recession began. As the chart shows, there is indeed a deficit beginning in the FY 2002/03.

But this was after 4 years of surpluses. And again, it is important to look at the source of this deficit. From FY2002/03 to FY2007/08 (that is, before the recession) public sector current expenditure averaged 37.3% of GDP, whereas during the Thatcher years (FY 1979/80 to FY 1989/90) public sector current expenditure averaged 39.7% of GDP (Redbook, C16). Labour spent less than Thatcher.

The deficit from 2002/03 onwards is because Labour taxed too little. Current receipts averaged 37.6% during Labour’s entire period of office, compared to 42.4% under Thatcher. Labour taxed much too little, much less than Thatcher.

Now, with an extra 4.8% of GDP in tax revenues under its belt (equivalent to £65bn currently) a Labour government could engage in a significant programme of investment , which remains the key to long-term prosperity. It would revive businesses and get people back to work, and get both back paying taxes, the key to reducing the deficit.

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