CHANCELLOR FOR A DAY

The role of the Chancellor is to set the governments budget. Budgets are financial plans. In this case the governments budget is the states tax and expenditure plans for the year ahead. Governments need to raise taxes from households and firms in order to finance the provision of public services, such as health care, education, defence and retirement pensions. In November 2009, in the pre-budget report, the Chancellor, Alistair Darling, announced that government spending for the year 2009-2010 was expected to total 676 billion. The breakdown of this expenditure is shown below:

Source: pre-budget report November 2009 During the recession government spending has risen quite sharply. The recession has caused unemployment to rise. As a result the number of people claiming job seekers allowance has soared, increasing the amount the government spends on social protection. The November 2009 pre-budget report also gave details on the governments tax plans for 2009-2010. According to Alistair Darling the government hopes to raise 498 billion from the following taxes:

The governments tax income has also been badly affected by the recession. There are three reasons why. First, unemployment has hit income tax and national insurance revenues because there are now fewer people in work. Second, corporation tax receipts are down sharply because bad losses caused by defaulting borrowers caused banking profits to evaporate. Finally, the collapse of the UK housing market caused stamp duty revenues to dry up.

So, in summary, this year the UK government plans to spend 676 billion, but only raise 498 billion in taxation to pay for this expenditure. This is called a fiscal deficit; a situation where planned government spending is greater than planned tax income. Fiscal deficits are usually financed by government borrowing. In this case this year the UK government plans to borrow 178 billion (498 - 676 billion = 178 billion). There are approximately 25m taxpayers in the UK. Therefore, this year the government has borrowed 7 120 on the behalf of each of these taxpayers.

My budget for the fiscal year 2010 2011

The amount of borrowing currently being undertaken by the UK government is unprecedented in peace time and unsustainable. According to, The Economist the UKs budget deficit is the highest in the developed world. At present the UKs annual budget deficit is equal to 14.5% of GDP. In comparison France and Germany are expected to run deficits of only 8.2% and 4.6% of GDP, respectively. Governments typically borrow to finance their budget deficits by selling bonds that generate a fixed income for the domestic and overseas investors that buy them. Over time, if a government continues to run budget deficits the national debt, the total amount owed to government bond holders, will rise. This is exactly what has happened in Britain over the last two decades. As the chart below shows the UK government has only managed to run a budget surplus on five occasions during the period from 1980 to 2009. This unwillingness on the part of politicians to balance the books means that the UK now spends more on debt interest than it does on transport!

In November 2009, the national debt, according to the Office for National Statistics, stood at 844.5bn, equalling 60.2% of UK GDP. This official figure is a gross under-estimate of the UKs national debt because the governments official figures exclude public sector debts run up by the Private Finance Initiative and Network Rail. In reality most economists believe that the UKs national debt is already close to 100% of GDP. This year the government has not had to find genuine buyers for its government bonds. The policy of quantitative easing has been used by the government to monetise the deficit; cash printed under quantitative easing (QE) has been used by the Bank of England to buy up the governments own bonds. According to, The Spectator, by

December 2009 the Bank of England had spent 186bn of freshly printed QE cash on UK government bonds, which was more than the 179bn of bonds sold by the government at this point during the same financial year. The practice of printing money to finance budget deficits has been used before. In Weimar Germany the government printed money to pay WW1 reparations. In the 1980s, Latin American countries, such as Argentina printed money to finance budget deficits. More recently, quantitative easing was also used by Robert Mugabe in Zimbabwe. Money printing in each of these countries caused hyperinflation and economic collapse. Printing money does not increase a countrys wealth; instead it tends to redistribute wealth from savers to borrowers.

Why cutbacks are necessary

There are three reasons why it will not be possible for the UK government to carry on running huge budget deficits. 1. Inflation is already starting to rise in the UK. The government and the Bank of England will find it hard to retain the confidence of international investors if the programme of quantitative easing is extended. If these investors believe that the UK government is trying to inflate its debts away they will dump UK assets, including government bonds before they lose value. The outcome of this scenario would be a sterling currency crisis. In addition, a sharp fall in the price of UK government bonds would lead to an equally sharp rise in UK interest rates. High interest rates would destroy the UK economy in its current state because households, firms and the government all have colossal debts. 2. The opportunity cost of paying interest. The national debt stands at over 33 000 per UK taxpayer. Each year the government will have to collect tax from the general public in order to pay the interest on this debt. Some economists believe that the UK is close to a destructive debt spiral; in order to pay the interest on its debts the government has to borrow. However, by doing so the national debt rises again, leading to a bigger interest bill. Rinse, lather and repeat. Taxes should be used to pay for public services, not debt interest. 3. The UKs creditors might lose patience with the UK government. The world demand for UK government bonds is not unlimited. If the UK government wants to carry on running huge budget deficits in the absence of quantitative easing the state will have to find genuine buyers for its bonds. These buyers will not be UK businesses or households; most are still maxed out with debt. To persuade foreign investors to buy additional UK government bonds they will need to be offered higher rates of interest. Higher interest rates would plunge the highly indebted UK economy back into recession To avoid a rise in interest rates the government must drastically reduce the size of the current budget deficit. By the end of the current financial year many economists believe that the UKs budget deficit will be close to 200bn. Budget deficits can be reduced in two ways: first, taxes can be increased, and secondly, government spending can be reduced. My budget will aim to halve the annual deficit from 200bn to 100bn; hopefully, this should be enough to placate our creditors, which will help to keep interest rates down.

How can the UKs budget deficit be cut from 200bn to 100bn?
The magnitude of the financial challenges facing the country should not be under-estimated. The budget for the whole of the NHS is 119bn, which is not far off the same amount that we need to cut from the budget deficit. My budget plans to cut the deficit are based on a combination of spending cuts and tax increases.

1. Tax increases
(a) Income tax High rates of income tax can reduce the incentive to work, which reduces output and employment. As a result I would not implement the new 50% income tax band. Instead, I would increase the basic rate of tax from 20% to 25%. The gap between the rich and the poor has grown under New Labour. To make the distribution of income more even again I would be in favour of reintroducing the 10% tax band for low income earners. At the margin

lower rates of tax might reduce unemployment by making it more financially rewarding to take up a low paid job, rather than living off government welfare benefits. In the UK interest income received by savers is taxable. This is wrong. The tax system ought to encourage saving, not discourage it. Saving is important because it helps to finance investment, which creates long-term economic growth. Until recently the bulk of the funds lent out by Britains highly geared banks were borrowed from overseas banks. The credit crunch began when British and American banks were no longer able to borrow from savers in creditor countries, such as China, Japan and Germany. One of the goals of my budget is to encourage long-term economic growth by encouraging saving, even if this policy results in a slow-down in short-run rate of economic growth. Rental income is also taxed in the UK. In the past decade banks lent out billions of pounds to buy-to-let property speculators. These scarce loanable funds should have been channelled into productive industry instead. The UK also runs a huge current account deficit, in addition to the budget deficit run by the UK government. Current account deficits occur when a countrys import expenditure exceeds its export income. The UK has been living beyond its collective means for far too long. As a result, UK household debt has soared to dangerous levels. To discourage the misallocation of investment funds the government should use the tax system to discourage buy-to-let property speculation. A new rate of income tax of 70% on rental income could be introduced, which should kill off the buy-tolet sector. Banks would then be forced into making more loans to businesses. These loans could help successful UK firms to expand, which should help to increase the UKs export income. (b) Increase inheritance tax Inheritance tax does not adversely affect the incentive to work because it is paid by the deceased, therefore, it should be increased. At present only those that fortunate enough to inherit over 325 000 pay inheritance tax. This figure is too high. I would reduce this threshold to 50 000. The current rate of inheritance tax is 40%. I would increase the rate to 75%. In any society there will always be some individuals who have more wealth than others. However, these differences in individual wealth should reflect the efforts made by individuals themselves, rather than good fortune. (c) Introduce a new 70% rate of capital gains tax on buy-to-let property The UK economy needs to move away from speculation towards saving and production. A new rate of capital gains tax could help the government to achieve this goal. Capital gains tax is paid on assets that have appreciated in value. To encourage long-term productive investment capital gains tax should not be applied to shares that have been held for more than 5 years. On the other hand, in order to discourage destructive property speculation a new rate of capital gains tax of 705 should be applied to capital gains on second-homes. (d) Tax wealth, rather than income The rich, armed with their accountants, do not tend to pay much in income tax because this tax is very easy to avoid, e.g. many investment bankers receive most of their pay via dividends, paid by off shore companies that they own. The income of the top 5% of income earners has soared under New Labour. These rich individuals should be forced into contributing more to society. Taxes on wealth are a lot harder to avoid than taxes on income. The proposal made by Vince Cable, the Lib Dem treasury spokesman, to introduce a mansions tax is a step in the right direction. Individuals that own houses or land worth more than 1m could be asked to pay a tax of 5% per year on the value of their asset.

2 Reduce government expenditure

In 1997 New Labour had the opportunity to make the case for a Scandinavian or German style economy based around higher rates of taxation, used to finance top quality public services. From Labours second term onwards UK public spending rose steadily in real terms. Unfortunately, a very high proportion of the money spent by Gordon Brown was wasted employing target setting bureaucrats. The flip side of this mistake is that it should be relatively easy to cut most of this expenditure without it affecting front-line services. In fact, in many cases, reducing the number of bureaucrats employed by the state could increase the output of the public sector. For example, in

education schools are now obliged to employ armies of administrative staff to collect and collate statistics used for inspection and self-assessment. These administrators spend their time producing pointless forms, which productive members of staff, otherwise known as teachers, have to spend their time completed. The time spent by teachers filling in paperwork could have been used for productive teaching and learning. The same principle applies to the NHS too. Many of the administrators and managers employed by Primary Care Trusts probably have a negative marginal physical product, i.e. their employment detracts from the output of the NHS. The state can no longer afford to pay these people that get in the way of productive doctors and nurses that deliver frontline services. In the NHS did not employ specialist managers. Instead, doctors and consultants made operational decisions. The 39bn spent by the UK government on defence should be cut. At the present time this we cannot afford this expenditure. On moral grounds this expenditure cannot be justified either. It could be argued that the UK should not be using its armed forces to occupy and kill the citizens of other countries for economic or religious reasons. Finally, the government should also consider tightening up benefit entitlement rules and reducing benefit rates in order to reduce the 190bn spent each year on social protection. It could be argued that an overly generous welfare state creates a moral hazard, which reduces the incentive to work.

Conclusion
Gordon Brown, Professor David Blanchflower and others that believe in the views of the English economist, JM Keynes, believe that the government should carry on running a budget deficit in order to inject purchasing power into the economy. According to this view the extra demand created by budget deficits will help to drag the economy out of recession. If the economy starts growing again our debts will become more manageable again. There will be no need to make cuts. This view is very optimistic on two counts. First, it assumes that the UK government will be able to find buyers for our bonds without interest rates going through the roof. Second, it assumes that governments can pump in endless amounts of demand into the economy without their being any adverse inflationary consequences. Keynesians believe that inflation is virtually impossible at the moment because the recession has created a huge amount of spare capacity in the economy, which will easily soak up the extra spending power created by the governments budget deficits. This view is incorrect. Recessions do not create spare capacity, instead recessions destroy capacity; firms that are forced into liquidation by a recession do not quickly re-open. In 1930s Germany, and more recently in Zimbabwe, hyperinflation was preceded by sharp rises in unemployment. Nevertheless the spare capacity created by high unemployment in both countries was not enough to keep inflation low in the face of quantitative easing by the state. Halving the UKs budget deficit will be extremely painful. Social unrest cannot be ruled out. However, the actions required to address the deficit must be taken because the consequences of not addressing the fiscal crisis, namely: hyperinflation, sky-high interest rates and currency collapse will be even more costly.