The trouble is that the fiscal system will break and there will be no happy ending

Fairy tales are comforting because the lead characters usually possess a special power and something magical turns up, enabling everyone to live happily ever after. Across Europe and the US, governments are running their budgets in such fantasy worlds. You do not need a particularly Germanic view of public finance to know this is unlikely to end well.

The Congressional Budget Office (CBO) warned last week that the US government finances were on an unsustainable path. The independent watchdog forecast that US government borrowing would be relatively stable over the next 10 years at about 6 per cent of gross domestic product.

That level would far exceed the 3.7 per cent average of the previous 50 years, a period that included the global financial crisis and the coronavirus pandemic. To give a starker comparison, prospective US borrowing is also about 50 per cent higher than that proposed by former British chancellor Kwasi Kwarteng in his 2022 “mini” budget, which blew up the UK bond market.

That alone would be sufficiently worrying if we could take the CBO figures at face value. But we should not because the congressional watchdog has been persistently too optimistic in recent years, partly as it has to base its projections on existing US government policy. This implausibly assumes most of Donald Trump’s 2017 tax cuts will expire at the end of 2025.

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It also assumes that the public spending restrictions in the 2023 Fiscal Responsibility Act will continue to bite after 2025. These suggest that discretionary US government spending including defence will decline from 6.4 per cent of GDP last year to 5.1 per cent in 2034. Over the past 50 years, these expenditures have averaged 8 per cent of GDP. These assumptions are also not credible.

Add to that the slightly optimistic assessment that the US government will be able to borrow short-term permanently at below 3 per cent and the true fantastical nature of these forecasts becomes apparent. Even though the CBO’s headline projection is that US public debt is not on a sustainable path and will rise from 97.3 per cent of GDP in 2023 through an all-time US record in 2028 and to 116 per cent in 2034, the prospects are significantly worse.

European debates

Although not as extreme, similar public finance fairy stories dominate European debates. Following the Kwarteng debacle and subsequent tax U-turns, independent forecasts by the UK’s Office for Budget Responsibility show UK debt stabilising as a share of GDP towards the end of the decade.

But these forecasts rest on the UK’s own fictions that the government will start increasing fuel duty in line with inflation, that the revenue benefits of immigration will have no implications for public spending, that restraint in public spending will come at a time of huge dissatisfaction in public services and that big cuts in government capital expenditure are consistent with accelerated progress towards net zero.

"Perhaps the biggest fantasy of all is the expectation that anything will happen to resolve unsustainable budgets without a crisis.”

We still do not know how the new European fiscal framework will operate in practice, but the debt sustainability analyses that will guide its work will be subject to the same panglossian forecasting assumptions evident in the US and UK. The position will be no easier when you add the twin structural difficulties in the euro zone that the European Central Bank looks likely to be slow in easing monetary policy, inhibiting European growth, and that fiscal differences between northern and southern Europe remain stark.

The bad news for all western countries is that on top of far-too-optimistic forecasting assumptions, maintaining the quality of health and social security programmes with rapidly ageing populations will require higher taxes without the prospect of improved services. That is a difficult electoral offer.

The good news is that the necessary consolidation of budgets is far from impossible so long as we don’t start falling for new fiscal fantasies.

On the political left, the most pervasive fiction is that all the necessary funds can be raised from “the rich” with next to zero consequences for the rest of the population. To raise the sums necessary, higher taxes have to extend much further down the income and wealth distributions. The more concentrated they are, the more tax avoidance activity will be encouraged, limiting revenues.

The greatest illusion for centrists is that there is a way to persuade the public that higher taxes and more public investment are needed and in all of our collective interests. Examples of open, honest and successful revenue-raising programmes which minimise distortions by also reforming taxes are noticeable by their scarcity. Even textbook attempts, such as the 2002 increases in UK national insurance, chose the tax least visible to the public but also with the greatest labour market costs.

On the right, the long-standing fairy tale of choice is that tax cuts raise revenues. While true in rare specific cases, the overwhelming evidence is that broad-brush tax reductions, such as those in the US in 2017, worsened the public finances, even if they were positive for growth.

But perhaps the biggest fantasy of all is the expectation that anything will happen to resolve unsustainable budgets without a crisis. We are much more likely to continue muddling along, pretending things are just about okay until something cracks. The trouble is that the fiscal system will break and there will be no happy ending. – Copyright The Financial Times Limited 2024