How to finance the UK government’s borrowing

Fiscal problems lie ahead for the next parliament

Much of the debate on UK economic policy has focused on rising inflation and the Bank of England’s slow response to it. But the greater problems for this parliament and the next will be the size of the fiscal deficit and the huge volume of gilt sales that will be necessary to fund it. The gilt market is where the world of fiscal policy – planning public expenditure, taxation and public borrowing – interacts with the financial markets. Any weakening of market confidence in the government’s ability to fund its deficits will confront whoever is in power with extraordinarily difficult decisions.

The Office for Budget Responsibility’s recent forecasts paint a gloomy picture for the UK’s public finances. The ratio of public debt to gross domestic product is at its highest for 60 years and is projected to stabilise before falling slightly in the next five years. Even this slight fall is open to question as it assumes unrealistically low growth of public expenditure towards the end of the period. Indexation of fuel duty is also assumed, though the track record is to waive this tax rise in annual budgets.

Furthermore, these high levels for public borrowing over the medium term are forecast despite large tax increases through the non-indexation of tax thresholds and allowances for income and inheritance taxes. These so-called ‘stealth taxes’ will be painfully clear to all who pay them.

Volume of gilt sales must skyrocket

The predicted high level of government borrowing will have to be financed primarily by the sale of gilts by the Debt Management Office. The volume of gilt sales that the DMO must achieve will be swollen by more refinancing of maturing gilts as the average maturity of government debt has been falling. The DMO has calculated that it needs to sell £237.8bn of gilts in 2023-24, a substantial increase from £169.5bn in 2022-23. The BoE will continue to sell gilts as it reduces the stock of £875bn of gilts that it accumulated while carrying out its quantitative easing policy. Its present intention is to sell £80bn of gilts in the year to October 2023. It is yet to decide on its sales target for the subsequent year, but it seems likely to be around the same level, or maybe higher.

Such plans for public borrowing and total gilt sales are not necessarily risky. Other G7 economies have inflated public borrowing plans and high debt to GDP ratios due to the triple shocks of the financial crisis, the Covid-19 pandemic and Russia’s war on Ukraine. Both the Federal Reserve and the European Central Bank have engaged in QE and are likely to start selling off their stock of government bonds.

Viewed from an international standpoint the UK’s fiscal position is not an obvious outlier. However, two factors complicate its position. Its inflation spike is higher than in comparable economies. This will inflate spending on debt interest through the uplift to indexed gilts of which the UK has issued more than other economies.

Second, as the OBR emphasises, a higher proportion of UK government debt is held by overseas owners than in comparable economies. If these are held primarily by long-term investors that have confidence in UK policy, such a high proportion held overseas is not a disadvantage. However, if there is a loss of confidence in UK policy, external holders of gilts, many of which may not have sterling liabilities that they need to match, could easily sell their existing gilts and hold off from buying new issues. The UK’s plans for public sector borrowing and gilt sales therefore depend to a great extent on foreign investors having confidence in its policies.

Conflict and convergence of approach between Conservative and Labour

The risks associated with these plans have prompted the two main political parties to adopt a cautious approach to the calls for tax cuts and additional public expenditure. The Conservative government has been resisting pressures to add to total public spending, notably from demands for increased pay. Where pay settlements are reached, these are intended to come from existing budgets. There has been no response to persistent pressures for tax cuts, which, if not financed by equivalent cuts in public spending, would lead to problems in financial markets similar to those of last autumn’s disastrous mini-budget.

The Labour opposition seems committed, at least initially, to the present government’s spending plans, except where increases can be financed by limited and specific tax increases, such as levying value-added tax on private education and abolition of non-domiciled individual tax status. However, there is considerable uncertainty about the likely yield of these relatively minor measures as both could generate defensive changes in behaviour that could significantly reduce the additional tax receipts.

This apparent convergence of approach by the two parties to the UK’s fiscal problems may not be as important as it seems. Besides macroeconomic and fiscal policy specialists, groups of politicians, academics and think tank experts are creating cases for significant increases in public spending in their respective areas – such as defence, education, overseas aid and, probably most powerfully, health – where the increase in UK spending as a share of GDP in recent years has not led to a reduction in pressures for more.

Crises of confidence

It is possible that the OBR and other forecasters may be too pessimistic about fiscal policy. Growth could be higher than expected and even higher than forecast inflation could lead to unexpectedly high-tax receipts. But such hopes are no basis for policy-making. It is as likely that the fiscal position will turn out worse than expected, either because of lower GDP growth and tax receipts, or due to irresistible pressures for higher public expenditure.

Last autumn’s ill-judged announcement of unfunded tax cuts gave a foretaste of what could happen if financial markets lose confidence as a result of unfunded fiscal loosening. The prices of government debt fell sharply, causing a crisis for insurers holding gilts who, in the absence of BoE support and the relatively swift abandonment of most of the tax cuts, would have been forced into defensive sales on a scale that would have driven gilt prices down further. There is no guarantee, with possible future crises of confidence, that it would be only insurers that would be affected and, therefore, forced into defensive sales of gilts.

What could be done to reduce the risk of such crises of confidence? None of the options would be easy and each would probably generate strong political opposition. The most obvious are the most difficult. Neither an increase in taxes (say via income tax or VAT) or major cuts in public expenditure (possibly to include welfare spending or by imposing or increasing charges for services) would be easy to achieve, even in a major crisis. Other potential measures could be considered to strengthen the public sector balance sheet and reduce the government’s targets for gilt sales. If there are assets that could be sold, this could be an option. The government could revive the last Labour government’s public private partnerships policy, provided that there was a genuine transfer of risk and that the future revenues that finance particular PPPs were not future government spending.

None of these options is without problems and would require careful preparation. But the consequences of a full-scale crisis of confidence would be worse.

Peter Sedgwick was head of the UK Treasury’s Forecasting Team 1986-90, its International Finance Group 1990-94 and a Deputy Director of its Public Services Directorate 1994-99. He was a Vice President of the European Investment Bank 2000-06, Chair of 3i Infrastructure 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.

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