Why does the government want to cut spending?

From nurses’ salaries to school supplies and state pensions, over £1 trillion will be spent on public services and investment this year.

Government spending has only been fully offset by tax revenues in six of the last 50 years.

More typical is an annual deficit averaging around 3% of the money the UK economy makes in a year.

But this is not the infamous “black hole” referring to a future sum shaped by the government itself.

let me explain.

The government can raise enough money to fund its spending by borrowing in the financial markets through bonds, which are essentially promissory notes. In order to borrow at relatively low interest rates, investors need to be convinced that this is a good choice.

So the markets are looking to governments to set and follow rules about how much they should borrow and how that debt is managed to demonstrate that they are financially responsible.

We won’t know the government’s exact target until Thursday’s fall statement. But it has indicated, as is fairly usual, that it will reduce the amount of debt – the sum of all our outstanding annual deficits – relative to our national income over the medium term (usually five years).

It’s the extra money the government needs to come up with to meet this self-imposed goal in the future, dubbed the black hole.

Covid-related aid packages pushed the national debt to its highest level since the end of World War II. Now the cost of energy bills and tax cuts have raised new concerns about debt.

Much depends on how the economy fares, but the independent Institute for Fiscal Studies (IFS) reckoned that after September’s tax-cutting mini-budget, over £60bn could be needed in 2027 just to bring the level of debt in to stabilize the relationship with the national income.

Many of September’s tax cuts have since been reversed, but some economists are still predicting that the government could have to come up with tens of billions of pounds by 2027 if it mandates such a target. The figure is uncertain and will depend on the measures in the autumn statement and the forecasts, assumptions and assessments of the government’s independent regulator, the Office for Budgetary Responsibility.

We don’t have to look far for a cautionary tale.

September’s mini-budget rattled markets as investors feared the biggest tax cuts in 50 years would leave the UK at risk of borrowing more than it wanted and also push up inflation. These risks caused bond investors to seek higher yields, so the interest rate — or yield — on those bonds skyrocketed, potentially adding billions to the cost of new government bonds.

Anyway, higher interest rates and inflation are driving up government borrowing rates—we were already prepared to spend twice as much on debt as we did on defense.

After the spate of tax turns, government bond yields fell. But the lesson is clear: ignoring a black hole is costly when looking to financial markets for funding.

There was no similar market reaction when the government rolled out big bills to help the economy through Covid as it had a willing customer for its extra debt. The Bank of England was then running its own support program – quantitative easing – which ended up buying a lot of bonds. But that was an emergency measure and will be processed.

Why can’t a government just print money to fund its plans? It may be tempting, but at a time of rapid inflation, it could put even more pressure on prices.

The panacea that all governments yearn for is faster growth. This brings in more money from taxes, reduces welfare spending and would reduce debt relative to UK income. But with warnings of a prolonged recession, it would be unrealistic to bet on it.

How the government decides to find the money, how to split the burden between tax hikes and spending constraints, is perhaps more a political than an economic decision.

And it can be undeniably painful when the sums are potentially that high. To illustrate, the IFS says the £35bn saving would equate to a 15% cut in the budget for all centrally funded public services, with the exception of defense and health. In other words, this sum represents more than £1 in every £8 spent on public sector wages.

What about tax increases? Freezing personal income tax allowances and bands (stealth taxes) or changing inheritance or capital gains taxes would take tens of billions of pounds out of the economy at a time when activity is already waiting for a slump. It would be a risky strategy as it could prolong the downturn.

Of course, the extra money doesn’t have to be raised before 2027. Why not wait and leave the dilemma to whoever wins the next election?

They could, but it’s the financial markets that the government wants to please, and the markets are not known for their patience.

So we will know very soon who will pay the price. The fall declaration may not bring much festive cheer. Instead of pre-Christmas delicacies, the belts in public service could be tightened and the tax burden increased. We’ll find out what that means for our money on November 17th.