A lot of newsprint has been devoted to the prospect of a
huge rise in public debt in the wake of the Covid-19 recession with the most
frequent question being “who is going to pay?” My answer is always the same: we
are. This is debt incurred in the name of taxpayers, and it is their tax
contributions which will ultimately be required to pay it down. But – and this
is the crucial point – it will not happen anytime soon. Indeed, economies tend
to pay down debt a lot more slowly than it is accumulated because, as I noted in a recent post, governments have an infinitely long life span which allows
them to charge future generations for debt accumulated in the past.
A case in point is the debt accumulated by the UK in the wake of World War II. It was only in 2006 that Britain repaid the last portion of the debt it owed to the US and Canada. The US loaned USD4.33bn to Britain in 1945, while Canada loaned USD1.19 bn in 1946. Ultimately the UK paid back USD7.5bn to the US and USD2 bn to Canada, implying an annual average rate on the combined debt of almost 1%. In effect, my generation was paying off debt incurred following a conflict that took place long before I was even born. Moreover, even with such a low effective interest rate, the UK still repaid an amount which was almost double the original principal. This should act as a cautionary tale for those who believe that economies can afford not to worry about how much they borrow at a time of ultra-low interest rates.
It is fascinating to look back over more than 200 years of public debt data in the IMF’s Historical Public Debt database to see how countries’ debt profiles have changed. Indeed many countries have registered debt-to-GDP ratios above 200% at some point with the UK the stand-out example, posting a ratio close to 270% in 1946. But even the now fiscally rigorous Dutch recorded a debt ratio of almost 250% in the 1830s and got close to these levels again in the late-1940s. France, which ended World War I with a debt ratio close to 240% was able to reduce it to 15% by the mid-1960s. These examples demonstrate that it is possible to eliminate high debt burdens without triggering domestic inflation, as Germany did in the 1920s, or default as many Latin American countries have tried over the past 40 years. As chart 1 illustrates, across a sample of industrialised countries debt levels are quite some way below their historical peaks, suggesting there may a bit of fiscal space to take on more debt. At the very least, it is likely that they can live with high debt levels for some time without having to take the axe to the public sector.
A case in point is the debt accumulated by the UK in the wake of World War II. It was only in 2006 that Britain repaid the last portion of the debt it owed to the US and Canada. The US loaned USD4.33bn to Britain in 1945, while Canada loaned USD1.19 bn in 1946. Ultimately the UK paid back USD7.5bn to the US and USD2 bn to Canada, implying an annual average rate on the combined debt of almost 1%. In effect, my generation was paying off debt incurred following a conflict that took place long before I was even born. Moreover, even with such a low effective interest rate, the UK still repaid an amount which was almost double the original principal. This should act as a cautionary tale for those who believe that economies can afford not to worry about how much they borrow at a time of ultra-low interest rates.
It is fascinating to look back over more than 200 years of public debt data in the IMF’s Historical Public Debt database to see how countries’ debt profiles have changed. Indeed many countries have registered debt-to-GDP ratios above 200% at some point with the UK the stand-out example, posting a ratio close to 270% in 1946. But even the now fiscally rigorous Dutch recorded a debt ratio of almost 250% in the 1830s and got close to these levels again in the late-1940s. France, which ended World War I with a debt ratio close to 240% was able to reduce it to 15% by the mid-1960s. These examples demonstrate that it is possible to eliminate high debt burdens without triggering domestic inflation, as Germany did in the 1920s, or default as many Latin American countries have tried over the past 40 years. As chart 1 illustrates, across a sample of industrialised countries debt levels are quite some way below their historical peaks, suggesting there may a bit of fiscal space to take on more debt. At the very least, it is likely that they can live with high debt levels for some time without having to take the axe to the public sector.
The key to long-term debt reduction – as I have noted on numerous previous occasions –
is the fiscal solvency condition which suggests that so long as nominal (real)
GDP growth exceeds the nominal (real) interest rate on debt, the debt ratio can
be reduced whilst still running a primary deficit. As Nick Crafts points out in
this nice blog post the UK was able to reduce the debt ratio from over 250% of GDP in 1948 to just
over 60% within 25 years despite running a primary deficit averaging 2.3% of
GDP which resulted from the expansion of the welfare state. As Crafts points out, “low interest rates, low unemployment, rapid
economic growth and tolerance for higher taxation all played a role” in
driving down the debt ratio. The idea that society was tolerant of higher taxes
is an interesting one and with many suggestions as to how the government can
find new ways to raise taxes, it is a theme I plan to return to in the near
future.
The notion of higher tax tolerance runs contrary to the economic model of the last 40 years in which governments have sold the idea of a low tax economy as the best way to allow the private sector to make resource allocation decisions. It has also allowed the state to take a back seat in some key areas of public service provision (e.g. rail and electricity networks). But what the proponents of low tax fail to point out is that this model may not be the best at delivering optimal social outcomes. There is, for example, a clear negative correlation between tax receipts as a share of GDP and rates of child poverty (chart 2).
The notion of higher tax tolerance runs contrary to the economic model of the last 40 years in which governments have sold the idea of a low tax economy as the best way to allow the private sector to make resource allocation decisions. It has also allowed the state to take a back seat in some key areas of public service provision (e.g. rail and electricity networks). But what the proponents of low tax fail to point out is that this model may not be the best at delivering optimal social outcomes. There is, for example, a clear negative correlation between tax receipts as a share of GDP and rates of child poverty (chart 2).
As governments begin to grapple with high debt levels, it is evident that they will have to think more creatively about revenue raising measures that do not necessarily rely on taxing the same old areas as before. When large numbers of people were in employment and governments were keen to promote investment, it made sense to tax incomes and allow tax breaks for capital. It is less clear that this holds today. And as I have noted previously, societies will have to determine what their priorities are. Scandinavian-style welfare provision is incompatible with US-style taxes. If the Covid crisis has taught us anything, it is that it may be time for an economic reset. Whether we are ready to confront the fiscal implications is another matter entirely.
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