4.5.3 - Public sector finances
Public sector finances are about how governments tax, spend, borrow and service debt. For exams, the key is to keep the main fiscal terms separate, then explain why deficits and debt change over time and why borrowing can be either stabilising or dangerous depending on the context.
Automatic and Discretionary Fiscal Policy
Fiscal policy affects the economy in two different ways. Some changes happen automatically through the tax and benefit system, while others happen only because the government makes a deliberate decision.
Definition: Automatic stabilisers
Features of government spending and taxation that automatically reduce fluctuations in the rate of economic growth.
Automatic stabilisers work without any new legislation. In a recession, incomes, profits and spending tend to fall, so tax receipts fall as well. At the same time, unemployment and low incomes usually increase transfer payments such as unemployment support. That means demand is supported automatically, so the downturn is usually less severe than it would have been otherwise.
In a boom, the reverse happens. Tax revenue rises and some benefit spending falls, so demand is dampened. Automatic stabilisers therefore reduce the size of fluctuations, but they do not remove the trade cycle altogether.
Definition: Discretionary fiscal policy
Deliberate changes in government spending and taxation to influence the economy.
Discretionary fiscal policy includes decisions such as cutting VAT, raising income tax, or increasing infrastructure spending. It can be expansionary when the government wants to raise aggregate demand, or contractionary when it wants to slow inflationary pressure. The advantage is that it can be targeted at particular sectors or regions, but it is also slower because recognition, decision and implementation lags all matter. It may also be influenced by politics rather than pure economic timing.
Automatic stabilisers are usually faster, but they are not costless. More generous benefits or higher effective tax burdens can weaken work incentives at the margin, so governments still have to judge the long-run effects of the system they build.
Deficit, Debt and Borrowing
Students often confuse the fiscal deficit with the national debt, but one is a flow over a period of time and the other is a stock built up over many years.
Definition: Fiscal deficit
The amount by which government expenditure exceeds government revenue in a given year.
If government spending is greater than tax revenue in a year, the government has to borrow to cover the gap.
Definition: National debt
The total accumulated borrowing of the government over time.
The national debt is the build-up of past deficits, reduced by any surpluses. So a deficit this year adds to the debt stock, while a surplus can reduce it. This is why economists describe the deficit as a flow concept and the debt as a stock concept.
In UK statistics, the headline measure of the deficit is public sector net borrowing (PSNB). A related measure, the public sector net cash requirement, is the cash amount the government needs to borrow over a period to meet its spending commitments. Both deficits and debt can be measured in money terms or as a percentage of GDP, but the percentage-of-GDP measure is usually more useful because it shows how heavy the burden is relative to the size of the economy.
The UK's fiscal deficit rose sharply after the 2008-09 financial crisis, to about 10% of GDP in 2009-10, and again during the COVID-19 period, to nearly 15% of GDP in 2020-21, because tax receipts fell while government support spending rose. Those annual deficits then added to the national debt: UK public sector net debt first passed £1 trillion in February 2010 and £2 trillion in June 2020.
Cyclical and Structural Deficits
Not all deficits have the same cause. A government may be borrowing because the economy is temporarily weak, or because there is a deeper mismatch between long-run spending plans and long-run revenue.
Definition: Cyclical deficit
The part of the fiscal deficit caused by the position of the economy in the trade cycle.
When the economy is in recession, tax receipts tend to fall and transfer payments tend to rise. That creates a cyclical deficit. As the economy recovers, much of that deficit disappears automatically because employment, profits and tax revenue improve.
Definition: Structural deficit
The part of the fiscal deficit that exists even when the economy is at full employment.
A structural deficit is the underlying deficit that remains even when the economy is producing at or near capacity. It suggests that planned public spending is persistently too high relative to the tax base. When the economy is at full capacity, the cyclical deficit is zero, so any remaining deficit is structural. In a boom, the cyclical element can even turn into a surplus.
For example, if the actual deficit is 5% of GDP and economists estimate that 2% is caused by a recession, the structural deficit is about 3% of GDP. Recovery can remove the 2%, but the 3% remains.
This distinction matters because recovery can solve only the cyclical element. If the deficit is structural, the government usually needs deliberate action such as spending restraint, tax rises, or policies that expand the tax base over time. That was part of the logic behind UK austerity after 2010: policymakers believed some of the post-crisis borrowing would not disappear automatically once growth returned.
Continue this lesson.
You’re previewing NovaLearn without an account. Create a free account to read the rest.
Create free account