The public spending ratio expressed as a share of GDP was only just entering the zone of fiscal sustainability following ten years of hard slog before Theresa May’s recent spending pledges. These commitments – that do not seem to have been discussed in advance with HM Treasury, which has to raise the funds required – mean that the UK government finances are now probably unsustainable in the medium term. This is particularly so, once allowance is made for the adverse effects of high governmental spending and tax burdens on aggregate supply and the sustainable rate of economic growth, which now seems to have slowed to some 1½% each year.
Apart from everything else, there are two specific time bombs threatening the public finances. One is the well-known demographic problem of the aging population, whose adverse consequences are still nowhere near their peak. A second issue concerns the rate of interest at which the current massive stock of government debt will have to be rolled over at, when it falls due for redemption. The 10 year gilt yield has already risen from just over 1% in the late summer of 2017 to 1.6% currently. However, the strength of the US economic recovery and other events over which UK governments have no control suggest that ten year yields could easily be a more normal 4% to 5% five or ten years from now, with double figures conceivable in the event of a government led by Jeremy Corbyn.
In terms of the tax ready reckoners discussed in my earlier blog, ‘An Orderly Brexit – What Cost to UK Taxpayers‘, Mrs May’s spending interventions could well require a 25 per cent rate of VAT, or something equivalent on income tax, to finance. Such a tax hike would massively damage the economy, at a very vulnerable moment post-Brexit. It would also gravely exacerbate the current ‘cost of living crisis’ and potentially lead to really serious social disorder. The alternative of allowing the budget deficit to take the strain would also be problematic, because of the upwards pressure it would place on gilt yields if it were responsibly funded. Irresponsible funding – i.e., yet more borrowing from the central bank – would be potentially highly inflationary. Unfortunately, one has to suspect that the present Conservative administration is highly likely to end up using high inflation to welsh on its debts because that would appear the easiest political option in the short term.
In general, the feckless government spending proposed by Mrs May is likely to do more harm to the UK economy and social harmony than a betrayal of Brexit. However, the two events are intimately connected, not independent. A successful Brexit will only be enabled in a low tax economy with a flexible supply side, while Brexit itself acts as an amplifier increasing the leverage of any given policy stance for better or for worse.