Defining prudence

In view of the obvious political opprobrium that higher taxes will bring on the Government, it is worth asking what precisely is the case for restraining the growth of government debt. In public debate, the case for lower debt is usually assumed to be self-evident. The word 'borrowing' has always carried unattractive political overtones, even before Mrs Thatcher turned it into a term of outright abuse. Consequently, whenever the PSBR is large, ministers can at least make out some sort of political case for unpalatable fiscal measures.

But why is government debt such a bad thing? Usually, debt is frowned upon because it is said to involve transfering 'a burden' on to future generations, a procedure often referred to as 'robbing our children'. But, when expressed in these simple terms, this argument is complete nonsense. The Government's debt is almost all owed to our own citizens, not to foreigners, so the nation as a whole does not transfer a net burden to future generations when debt increases.

What does happen, however, is that future UK citizens need to pay more tax in order to service the Government's interest payments which will in future be made to other UK citizens. This leaves the nation as a whole no better or worse off. Indeed, the citizens on either side of the ledger may easily be the same people.

Thus an increase in public debt involves nothing more than a series of transfers between British individuals. When the debt is incurred, savers make a transfer to the taxpayer. When the debt is serviced or redeemed, taxpayers make the reverse transfer back to savers. The act of increasing debt - for any given level of public expenditure - is therefore equivalent to a postponement of the need to raise tax revenue.

This may or may not be a bad thing. Both Keynesian and classical economists would agree that a build-up of debt during a recession can enhance an economy's long-term performance, provided there is a presumption that the debt will be paid off in subsequent booms.

The Keynesian case for running a government deficit in a recession is familiar and obvious. When private sector demand is slack, an excess of government revenue over expenditure will help to stabilise the level of output in the economy.

The classical case is more subtle. This is based on a belief that taxation has distortionary effects on the economy. Income tax, for example, reduces the return-to-work effort and may therefore reduce GDP.

According to the classical textbooks, the optimal way of dealing with these distortions is to set tax rates such that the budget is balanced over the medium term, and then leave these tax rates unchanged as the economy experiences booms and slumps. This naturally implies that the budget will move into deficit in recessions and into surplus during subsequent upswings.

In either Keynesian or classical systems, it is therefore perfectly acceptable for the Government to run a substantial deficit in a recession. Furthermore, classical models give us some clue about how much the PSBR should be allowed to rise during the recession - it should simply be the 'automatic' increase in the PSBR that occurs when the cyclical decline in tax receipts takes effect.

So far, these arguments can be used to justify fluctuations in the level of government debt in the course of an economic cycle, but we have said nothing about the long- term average level of debt around which these cyclical fluctuations should take place. Some economists would take the view that this average level should be zero, since any government that knowingly uses debt to postpone the need for tax receipts must be acting irresponsibly.

This argument makes sense when applied to the Government's current expenditure - why should future taxpayers contribute to financing services that are consumed today?

But it is far too stringent when applied to the Government's capital expenditure. For example, the building of a school or a hospital will continue to provide useful services to taxpayers for several generations, and it is perfectly reasonable to use government debt to spread the tax payments needed to finance such long-term capital spending.

Ideally, the average stock of government debt over the course of an economic cycle should therefore be approximately equal to the stock of public sector fixed capital net of depreciation. The problem is to produce a sensible valuation of the Government's capital stock. What exactly is a second-hand Trident submarine worth?

So great is the difficulty of valuing government capital in sectors of the economy where there is no market place that many economists have given up the chase. They have suggested that the Government should accept the level of debt bequeathed to it by its predecessors and ensure that it does not pass on a worse public sector balance sheet position.

What does this mean in practice? If the Chancellor wishes to stabilise the debt-GDP ratio from the end of this Parliament,he needs to reduce the PSBR in 1997 to about 3 per cent of GDP. He must be sure he can justify any extra borrowing on top of this by arguing that it is being used to increase the fixed stock of public sector capital - roads, schools and so on - net of depreciation.

Since depreciation is so massive each year, it is doubtful whether the net investment of the public sector is strongly positive. In the US, for example, it is generally thought to be close to zero. If this is also true in Britain, the Government should seek to reduce the PSBR to about 3 per cent of GDP by the late 1990s.

Assuming this target is accepted, the case for further tax increases - based solely on considerations of public finance - is not all that strong. This is because there is a good chance that the PSBR objective will be hit automatically as the economy recovers.

Therefore, the case for tax increases rests on other grounds, including the need to boost expenditure on education and training and to change the mix of fiscal and monetary policy. These are far removed from the usual 'balance the books' arguments that dominate the public debate but, if that is the only way to sell to the public a desirable increase in taxation, so be it.