Government borrowing is something that’s often spoken about, but it’s a topic that leaves a lot of people confused. It’s not easy to understand why the government borrows money and how, and the impact government borrowing has on the rest of the economy. In this blog, we have taken a look at the ins and outs of government borrowing, including the reasons behind it.
Why Does the Government Borrow Money?
The government borrows money for a variety of reasons, usually when their expenses surpass the income generated from taxation. Taxes are the main source of government revenue, collected through income tax, VAT and corporate taxes. However, there are limits to how much money the government can raise through taxes, without having a negative impact on the economy. Higher taxes mean individuals and businesses have less money to spend, which can lead to reduced consumer spending and business investments. This can slow down economic activity, potentially leading to job losses and decreased profits for businesses. When faced with a shortfall, the government borrows money to support operations and economic growth.
There are two main reasons for government borrowing. Firstly, by borrowing funds and injecting them into the economy, the government can increase demand, create jobs and support struggling businesses. Secondly, governments borrow money to finance large projects such as building railways, roads and utilities. These projects are key for long term economic development and can provide substantial benefits to society.
How Does the Government Borrow Money?
Most government borrowing is done through bonds. These bonds come with a promise from the government to repay the borrowed amount at a specified future date, along with regular interest payments throughout the lifespan of the bond. These bonds are considered to be safe investments because they’re backed by the government’s credit. Pension funds, investment funds, banks and insurance companies are the main buyers of bonds. Bonds give them a reliable way to earn interest while keeping their investments relatively safe.
Government borrowing can also be done by quantitative easing, which is when the Bank of England buys government bonds. By doing this, the Bank of England injects money into the economy, which can help to encourage economic activity and keep things running smoothly.
Government Borrowing, Interest and National Debt
Government borrowing changes from year to year. For example, in the 2022-23 financial year, the government borrowed £128.4 billion, which was £5.5 billion more than the year before. The total amount the government owes is referred to as the national debt, currently standing at around £2.6 trillion. Though this may seem high, compared to previous years and other leading economies, today’s debt levels are considered to be relatively low.
As the national debt grows, so does the interest that the government must pay. This is manageable during periods of low interest rates, but this cost becomes more difficult to afford as rates rise. During the 2022-23 financial year, the government allocated £108 billion towards debt interest payments, which was more than what was allocated to education. This highlights the importance of managing the national debt effectively, in a way that prioritises funding for critical areas.
The Impact of Government Borrowing
Some people warn against excessive borrowing, expressing concerns about its potential harm to the economy and future generations. They argue that increased borrowing could result in higher taxes, reductions in public spending on essential services, and higher interest payments on the national debt. As people retire and pension payouts rise, there could be a strain on government finances, leading to decreased tax revenue.
Others hold a more optimistic view, believing that large economies like the UK have the capacity to sustain increased borrowing without too many negative consequences. It’s important for government borrowing to find a balance between the benefits and risks, considering both short term economic growth and long term financial sustainability.
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