UK: REDUCTION IN BORROWINGS OFFER LITTLE SCOPE FOR TAX CUTS. - Recovery in economic activity hides the true deficit position.

Last Updated: 31 Aug 2010

Recovery in economic activity hides the true deficit position.

Governments have been congratulating themselves this year. In every one of the G7 countries, except Japan, the public sector will borrow less this year than it did last. Some of the sharpest improvements can be found in Europe where the UK, Germany and Italy have all cut their deficits. The US has also made headway: its expected deficit of $160 billion will be the lowest as a percentage of GDP since 1979. So what scope do the authorities now have for cutting taxes?

While governments certainly deserve credit (for past decisions to increase taxes and squeeze public expenditure), the decrease in borrowing is also due to recovery in economic activity, which has boosted tax revenue and reduced spending on unemployment. To disentangle these effects we need to know the size of the structural deficit, ie the amount that a government would borrow if economic activity were at a normal sustainable level. This reveals that the US position is worse than the headline figure suggests: with the economy operating above its normal level, the structural budget deficit is estimated at 2.5% of GDP compared to a likely outturn of 1.8% (see chart). However Europe has greater problems. Although borrowing should continue to fall as activity returns, the structural deficit is expected to remain at over 3% in most countries. Since 3% is reckoned the maximum which an economy can sustain in the long term, Keith Wade, chief economist at Schroder Economics, argues that permanent tax cuts can only be justified if matched by reductions in public expenditure.

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