(This is an archived page, from the Patterns of Power Edition 3 book. Current versions are at book contents).
Politicians gain popularity by offering benefits to people, so they want to increase government spend – but this has to be paid for from taxation, which is unpopular.
Governments set a budget for how much they want to spend and they set tax rates which are designed to collect the necessary funds. But forecasting tax revenues is difficult: the level of economic activity in a country depends on unpredictable factors and upon the economies of other countries (126.96.36.199). If the economy grows less strongly than expected the tax revenues will be lower, and the costs of benefits will be higher, than budgeted.
In their desire to please people (particularly if an election is imminent) politicians tend to make over-optimistic assumptions. The British government’s decision to set up an Office for Budget Responsibility in 2010 was intended to restore city confidence in economic forecasts. As BBC Economics editor Stephanie Flanders explained, in a blog post Why the Office for Budget Responsibility matters, this followed a period when “the revenue and borrowing forecasts in the latter years of the Labour government were objectively atrocious”.
If governments spend more than they receive in tax they have a so-called ‘fiscal deficit’ and they have to borrow to make up the difference. This borrowing can create problems:
· The debt has to be paid back, so tax will have to be higher in subsequent years: possibly placing a burden upon those who had no influence upon the decision to incur the debts and who had not benefited from the increased government spending at the time when the debt was incurred.
· If government borrowing in a restricted pool of available finance causes a rise in interest rates, its impact is to further reduce consumer demand and to increase the costs of wealth creation – preventing a return to economic growth.
· Markets will charge higher interest rates to a government if there is doubt whether it will be able to repay its debts. A BBC article, Timeline: The unfolding eurozone crisis, recorded how some countries in difficulties faced increased borrowing costs during the Eurozone crisis in 2011. The increased rates further reduce those governments’ ability to repay their debts, in a vicious spiral.
· If governments control their own currencies they can repay debts by printing money. This is inflationary and is a serious problem in itself, as described later (188.8.131.52).
It can be seen that it is imprudent for a government to allow its debt to continually increase. If a government has entered into long-term commitments that exceed its average tax revenue it is running a so-called 'structural deficit' which is unsustainable and has to be corrected – either by cutting government spending or by increasing taxation. Such corrections are painful and reduce economic growth.