Is the Treasury ‘crying wolf’ over the debt interest bill?

The latest data on the UK’s public finances have provided more ammunition for those arguing that the government cannot afford to cut taxes. However, the economic reality is far more nuanced – especially when it comes to debt interest payments.

The bad news is that the government borrowed another £14.0 billion in May, £3.7bn more than forecast by the Office for Budget Responsibility (OBR). This reflected both lower-than-expected tax receipts, despite the increase in National Insurance contributions, and higher spending, including £7.6 billion in debt interest costs.

Along with unfavourable revisions to April’s numbers, this means that the government has already borrowed £35.9 billion in the first two months of the new fiscal year, or £6.4 billion more than forecast.

To rub it in, these figures will get much worse before they get better. In particular, debt interest costs will almost certainly top £20 billion in June alone, because the inflation uplift on index-linked government bonds (gilts) will be based on the jump in the Retail Price Index (RPI) between March and April.

This OBR was already forecasting that debt interest payments will cost the government over £87 billion this year. A figure nearer £100 billion is now plausible.

This has led a number of well-placed commentators to rally to the support of the Treasury. For example, Robert Peston was quick to compare the £100 billion to government spending on education, and to endorse the Chancellor’s line that “rising inflation and increasing debt interest costs pose a challenge for the public finances, as they do for family budgets”.

But this is indeed, I’m afraid, ‘crying wolf’.

For a start, it is misleading to compare the £87 billion (or £100 billion) bill for debt interest to annual spending on, say, defence and justice – or education. This is because the RPI uplift applies to the ‘principal value’ of index-linked gilts (the amount that bond holders receive when the bonds mature), and will only be paid out when these bonds are redeemed – over an average of around 18 years. This is not the same as the budgets for departmental spending in a single year.

In May specifically, the RPI uplift on index-linked gilts contributed £5.0 billion (or roughly two-thirds) of the £7.6 billion in central government debt interest costs. It is therefore more accurate to describe the £7.6 billion as the interest ‘payable’ (on an accruals basis), rather than the amount actually ‘paid out’.

The fact that these higher debt interest payments will be spread over many years also undermines the argument that the government cannot afford to cut taxes now. Looking instead at actual cash flow, higher inflation will still provide a windfall to the Treasury, as rising nominal incomes and higher prices feed through into higher tax receipts.

Indeed, despite the bad news on new borrowing, the public debt to GDP ratio of 95.8 per cent in May was actually 0.1 per cent below the latest forecast. This is presumably because the denominator, which is nominal GDP, was higher than expected. In other words, higher inflation still reduces the real burden of government debt.

Rising inflation and debt interest costs therefore pose a much smaller challenge to the public finances than they do to family budgets. In particular, the government’s income rises automatically when inflation increases, because the tax base is larger. The government is also much better able than households to spread the cost of interest payments over time.

To be clear, it would also be irresponsible to argue that we can forget about the additional debt interest costs, just because they will not actually materialise for many years. Nonetheless, payments in the future are usually valued differently than payments now.

In this case, assuming at least some real growth in the economy, the burden of paying £100 billion in dribs and drabs over many years, even if uprated in line with inflation, should be less than the burden of paying £100 billion in one chunk now.

What’s more, the RPI uplift will have relatively little impact on the government’s cash requirement (known in the jargon as ‘CGNCR ex’) in 2022-23. This is the amount that actually has to be raised from the markets to cover the gap between cash inflows and outflows. Put another way, there will still be plenty of cash to spend on other areas, without having to issue loads more new gilts.

In short, will the government really be spending as much as £100 billion on debt interest this year? In purely accounting terms, and on an accruals basis, the answer could be ‘yes’, and that is all some might care about. But in my view, this figure gives a misleading picture of the economic, financial and policy implications of the jump in debt interest costs.

The government did not, in fact, hand over £7.6 billion in debt interest last month – and nor will it be paying out anywhere near £100 billion this year either. And it is rather odd to worry about the impact of higher inflation on the cost of index-linked gilts when the real yields on these bonds remain firmly negative!

It is therefore still right to view each proposal for tax cuts – or spending increases – on its own merits. These benefits could actually include reducing inflation, both directly and indirectly, or at least doing more to ease its impact on households and businesses. In the meantime, parroting dodgy arguments about the impact of inflation on the public finances is no help to anybody.

This article was first published by The Spectator on 23rd June 2022

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