Government borrowing has surged over the past five years, producing record budget deficits. Economic activity is now strengthening in the US and UK and politicians worldwide hope that recovery will restore the health of public finances without the need for further tax increases and spending cuts. Recent OECD calculations suggest they will be disappointed, says Schroder Economics. The chart breaks the forecast 1994 budget deficits into a cyclical component - reflecting the economic downturn - which should disappear when activity picks up; and a structural part which will remain even when activity returns to normal.These figures include tax plans already announced. The OECD believes that, even as growth resumes, a large structural element will persist, particularly in Europe. This suggests that further tax increases/spending cuts will be required. The root of the deficits lies in the late '80s when governments mistook strong demand for sustainable growth and made tax cuts and spending increases. Fiscal retrenchment is now needed to match tax and expenditure plans with less activity. Assuming tax increases and spending cuts are introduced, interest rates will have to be low to offset the effect of higher taxes and ensure growth continues.
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