Article by Richard Wellings in Offshore Investment

Our politicians have created an economic time bomb. Profligate public spending at a time of deep recession has led to a severe fiscal crisis.

This year about one in every four pounds spent by the British government will be borrowed. In the United States, the ratio is even worse.

The dangers are huge. The last time the UK ran such large deficits was during World War II. And this was only possible through special loans from the US – now the world’s biggest debtor.

Today nearly all major Western governments are trying to borrow vast sums at the same time. Meanwhile, China is engaging in a stimulus package that is depleting its vast reserves, and resource-rich countries such as Russia have seen their surpluses disappear as the price of commodities has fallen.

In the medium term, it is difficult to see who will lend such unprecedented sums to already heavily indebted governments. Indeed, if there is no clear action plan to tackle the deficits, investors in bonds will at the very least demand a substantial risk premium.

This would mean a rise in interest rates. Governments would then have to spend more on loan repayments, threatening a debt spiral in which borrowing is increased to pay off existing liabilities.

In the worst-case scenario, politicians may be tempted to monetise the debt by printing money. In the twentieth century, large and persistent budget deficits were often followed by periods of high inflation.

But even if inflation is avoided, government borrowing on such a scale is likely to ‘crowd-out’ private investment. Resources will be diverted from wealth creation into unproductive bureaucracy and wasteful, politically-driven spending.

Unfortunately, demographic trends will make it even harder to balance the books. Western governments face enormous unfunded pension liabilities. (Public sector pension liabilities amount to around £1,200 billion in the UK alone.) Rapidly ageing populations are also increasing the burden on state-funded health and welfare systems.

It is therefore essential that borrowing levels are brought down as quickly as possible. And this has important implications for taxation. Taxes must rise or government spending must fall or there will have to be some combination of the two options.

Increasing taxes will do significant economic harm by discouraging hard work, entrepreneurship and innovation. Investment levels are also likely to be reduced, with the government taking a larger share of economic resources that could have been put to productive use in the private sector.

Moreover, with taxation levels already at relatively high levels in many developed countries, it is doubtful whether raising taxes further will bring in as much extra revenue as expected.

A good example is the UK’s planned 50% income tax rate. It will raise little in the short term, perhaps a few hundred million pounds a year, a drop in the ocean compared with a deficit approaching £200 billion. And its effect on private sector growth means it is likely to be counterproductive in the longer term – high tax economies find it harder to attract talent and investment from abroad.

Cutting public spending would therefore be far more effective than raising taxes at tackling government borrowing without undermining wealth creation. But it will be very difficult politically.

Throughout Europe and North America, a high proportion of the voting population is now directly dependent on state spending, whether as public-sector workers, welfare claimants or state pensioners. This represents a large electoral bloc with a vested interest in continued government largesse.

But the scale of the fiscal crisis is so great that tinkering won’t be enough. Cuts will have to be applied to the major areas of state spending – health, education and welfare. It is inconceivable that sufficient savings can be made elsewhere.

Politicians talk about improving efficiency through reform. But such initiatives, though laudable, take years to introduce and often fail. In reality, large spending reductions are needed immediately and these are likely to prove deeply unpopular among certain groups.

Accordingly, politicians may find it easier to raise taxes rather than push through difficult spending cuts, notwithstanding the negative effects on the economy. While taxpayers are dispersed and fragmented – making it difficult for them to organise in opposition – there are powerful professional lobbies in the public sector that will fight tooth and nail to protect their privileged positions.

Government workers are also heavily unionised in most countries. Faced with pay cuts and redundancies, they may choose to take strike action, despite the resulting disruption to essential services.

Tackling the fiscal crisis will therefore take immense political courage. Yet delaying the necessary action is likely to have a terrible economic cost and leaders must look beyond short-term electoral considerations when considering their options. Western economies will become even less competitive if taxes rise further as a result of politicians’ cowardice.

Dr Richard Wellings is Deputy Editorial Director at the Institute of Economic Affairs.

Further reading:

How Should Britain’s Government Spending and Tax Burdens be Measured? by David B. Smith.