Note: in retrospect (November 2015) this was a little bit amateurish. Give it a miss!

Budget 2013 (reviewed here) shows that the UK’s ‘headline’ deficit was around £121 billion last year, will be £121 billion again in 2012/13, and will be a predicted £120 billion in 2013/14. There has been much commentary about the robustness of this year’s figure in particular. But this is not the measure on which the government is aiming to close the deficit, and mistakenly emphasising the overall deficit may even be harmful.

The graph below shows four measures of the deficit using Table 1.5 of Budget 2013*. Our choice of measure clearly makes a big difference in determining the size of the deficit and when it will (in theory) be closed. Looking at each can also help break down the causes of the deficit. It may even be that the government is emphasising the wrong measure.

1: Public Sector Net Borrowing (blue)

The blue line is the simplest, most obvious measure of the deficit: the difference between what the government spends and what it raises in taxes. It has increased from around 2-3% of GDP a decade ago, and was 7.9% last year. This is the £121 billion deficit.

But – for the reasons discussed below – we should not be aiming to close this through spending cuts and tax increases, and indeed this is not the government’s aim.

2: Cyclical-adjustment (red)

During an economic downturn, tax receipts fall and social security spending goes up. These automatic stabilisers are a good thing for the economy, but to get an underlying view of the deficit we should try to exclude such temporary changes. This is what the red line tries to do. The difference between the red and blue lines is the part of the deficit that’s down to the economy temporarily running below its full potential.

This has big policy implications. If the deficit is all down to an economic slump, the solution must be growth rather than cuts; if the economy is judged to be already operating at full capacity, we can’t expect to close the deficit through growth. The UK finds itself somewhere in between, having run an overall deficit (rightly or wrongly) for 37 of the past 43 years – regardless of economic conditions.

The Office for Budget Responsibility (OBR) estimates how much of the overall deficit is down to economic weakness, and this has a huge impact in determining austerity plans. But, unlike net borrowing, estimating the potential size of the economy and what the public finances would then look like, is far from an objective measurement. Amongst independent forecasters, estimates for the economy’s ‘output gap’ range from -0.8% to -6% of GDP, with the OBR’s figure “roughly in the middle” (IFS Green Budget, Chapter 5). As Gavin Kelly has written, a small gap is “bad news for our economy, as we’ve had a bigger permanent loss in productive capacity than many realise. And it’s bad news for austerity: the return to growth won’t fill the fiscal gap”. But if the OBR has been too pessimistic, “the structural deficit is far smaller than we are being led to believe – and Osborne may be planning to tighten fiscal policy by way too much.” If we wish to close the cyclically-adjusted deficit, the difference between the most optimistic and pessimistic forecasts represents a staggering £57 billion of spending cuts and tax increases (IFS).

But despite these problems, and the need to reconsider fiscal targets at the next election, cyclical adjustment should and will remain a key part of how the deficit is assessed.

3: Also excluding investment (yellow – the cyclically-adjusted current budget balance)

The Chancellor’s ‘fiscal mandate’ includes cyclical adjustment but also excludes public sector net investment. This is money spent on building schools, roads, railways and other infrastructure that benefits future taxpayers and gives a high return on investment.

As a key part of Labour’s ‘golden rule’, and now Osborne’s too, I will take it as given that excluding investment spending from the deficit target is appropriate.

Note that this makes even more puzzling the Chancellor’s decision to follow the previous government’s plans to cut investment (a choice which is being gradually reversed). As he introduced a target that deliberately excluded investment, capital spending could even have been increased without negatively affecting his principal target.

4: Also excluding debt interest (green – what could be called the cyclically-adjusted current budget primary balance!)

The budget also lists the UK’s ‘primary balance’. This simply subtracts from the deficit what the government spends (net) in debt interest. The green line does the same in relation to the Chancellor’s measure. This debt interest is a remarkable chunk of GDP, having risen from around 2% (historically quite low) to 3% following financial crisis. This is despite Quantitative Easing and the government’s record low cost of borrowing. The cost will certainly increase further, and may be £70 billion per year by 2017 (though consider that much of this goes to UK pension and insurance funds).

One may question how useful the primary balance is in practice, as the cost of debt interest must be met like any other spending (it has even been suggested that this cost would itself make for a more meaningful fiscal target). However, excluding this cost helps shine a light on whether the state is unsustainably large (aside from whether any given size is desirable). If we had a primary balance surplus but overall deficit, that would not be an argument that our current level of public services and taxes were fundamentally unsustainable; only that the state had previously overspent. That situation could be resolved, in theory, by explicitly temporary measures to reduce the national debt (per cent of GDP): in the longer-term, spending cuts or tax increases could then be reversed.

One can almost imagine the Chancellor saying in 2014/15, “Excluding debt interest, the tough decisions we’ve taken have balanced the (cyclically-adjusted) current budget. The deficit still remains, but OBR figures show this is due only to the headwinds still facing our economy and the cost of debts caused by the previous government. Britain must temporarily tighten its belt further to reduce this debt burden.” When the only thing standing in the way of the government’s deficit target is debt interest, the Bank of England’s government bond actions might be considered even more important and novel one-off ways to reduce the national debt burden may become more attractive (the cost of borrowing is clearly important too but only applies to new debt, and is largely out of the Treasury’s hands).

I would be interested to hear from others as to whether it’s reasonable to exclude both debt interest and net investment (as well as making cyclical adjustment), and whether balancing the books by this measure would indeed mean that further spending cuts or tax increases – including some of what is already scheduled – could be considered (relatively) temporary.

Originally published at https://centreforumblog.wordpress.com/2013/04/02/how-to-close-the-deficit-by-2014/