Debt and taxes

Government debt is a problem in both high-tax France and low-tax America. Spain hasn't approved a budget since 2022. The UK's tax rate is back at 1970s levels. Fiscal policy is in the headlines, then. But which matters most, borrowing or taxes? Government net or gross?

The two are related of course. Other things equal, higher taxes mean lower debt. But as the first example above shows, other things are not always equal.

Talking heads focus mostly on the former. Debt and deficits get most attention, and there are all sorts of clever "rules" to try to restrain them, especially in Europe.

Currently, for example, borrowing is being blamed for bond yields at historic highs (by the standards of recent "history", that is).

The pundits should know better, however. That's not the main reason yields are rising.

In reality, a lasting link between government debt and bond yields, whether across time or countries, is not visible to the naked eye. What is visible, though, is a link between yields and the business cycle (inflation and growth), as we argue in Market Perspective.

The noise around debt, then, can be overdone. By comparison, the level of taxes gets much less attention – but may be just as important economically.

Had I read that last sentence as a student, or a junior Bank of England economist, I would have disagreed with it. I would not have imagined I would one day write it.

But watching, reading and pondering, in both private and public sector contexts, has left me thinking that the size of government – which is what taxes reflect – does matter.

Higher average tax rates – government revenues relative to GDP – are usually associated with higher public spending. The gap between spending and revenue may get most of the attention, and gives rise to the debt, but it is usually small by comparison with either.

Tax and spending rates show how large public sector activity is in the context of the wider economy. As illustrated above, they can diverge from debt levels. A small government can have a lot of debt (the US, for example), and vice versa (Norway).

Like debt, the size of government may not affect bond yields directly, but it can influence wider economic performance. There is a link, across time and geography, and not just because of the grim experiences of collectivist economies.

There are, however, few rules to govern it – even in Europe. Here in the UK, where we have more fiscal rules than most, none of them relate to overall tax or spending rates (though a "welfare cap" does apply to a specific category of spending).

Of course, governments must have scale. Efficiency requires public goods like law, defence and utilities, and the tackling of externalities. If we are to think of ourselves as civilised, we need a safety net against unemployment, ill health, or plain bad luck.

Libertarian minimalism is no more feasible than full collectivism. So by trial and lots of error, we have arrived at the unsung triumph of the modern "mixed" economy, a wealth and liberty-creating mechanism without equal.

Within it, however, the right "mix" of public and private is a grey area. Exactly how the non-negotiable elements of government provision are provided, and what else is done besides, is up for debate.
Economists rarely take part in this debate, for all sorts of reasons. We often prefer the neatness and (spurious) precision of maths to the real world. Our Keynesian macro focus overlooks the micro context in which tax and spending rates matter.

Some of us try to keep "positive" analysis distinct from such politically-loaded "normative" issues; others study economics to begin with because there are social problems to which "bigger government" might be an answer.

Arguably, though, economists should be as vocal about big government as we are about big debt.
Back in the day, my public finance prof at LSE derided the "Laffer curve" showing government receipts falling when taxes rise to some high level. Today we take it for granted that some such effect exists.
Arguments in the 1970s and 1980s that badly-designed safety nets can reduce labour supply were seen (by me too) as "normative", insensitive even. Today, such a possibility is routinely accepted even by leftist politicians.

Most tellingly, perhaps, Mario Draghi, whose establishment credentials are impeccable, explicitly points a finger at big government. His high-profile 2024 report cites regulatory burdens and larger governments as a cause of Europe's poor competitiveness.

Big government's intentions are good, but there can be unintended consequences. This may indeed be something we realise more as we get older, as our day-to-day experiences of getting things done (or not) grow. Consultation and due diligence are necessary, but not costless; meanwhile, big politics can be performative as well as functional.

Something to bear in mind, perhaps, when the deficits and debt headlines disappear from the headlines…

Past performance is not a guide to future performance and nothing in this article constitutes advice. Although the information and data herein are obtained from sources believed to be reliable, no representation or warranty, expressed or implied, is or will be made and, save in the case of fraud, no responsibility or liability is or will be accepted by Rothschild & Co Wealth Management UK Limited as to or in relation to the fairness, accuracy or completeness of this document or the information forming the basis of this document or for any reliance placed on this document by any person whatsoever. In particular, no representation or warranty is given as to the achievement or reasonableness of any future projections, targets, estimates or forecasts contained in this document. Furthermore, all opinions and data used in this document are subject to change without prior notice.