Originally published at: A guide to the government’s finances (in charts) – InvestEngine Insights
Rachel Reeves has warned that Britain’s new Labour government has inherited “the worst set of circumstances since the second world war”, as she instructed the Treasury to examine previous spending under the Conservatives (source: the FT).
What does she mean by this? Are the UK government’s finances really in such a dire state?
What is the deficit?
When the government’s expenditures exceed its income from taxes and other sources, it borrows to bridge the gap. This borrowing is termed ‘public sector net borrowing,’ commonly known as the deficit.
To finance the budget deficit, the government issues bonds. These bonds can be traded on secondary markets by the investors who purchase them, and are what’s held in the UK government bond ETFs on our platform.
Why does the UK have a deficit?
To understand this, it’s first useful to understand how the government raises money and spends money.
The government raises money in many ways, but over half of government receipts are made up of PAYE income tax, National Insurance Contributions (NICs) and VAT:
The split between government receipts has remained relatively stable throughout recent history, with the big 3 taxes accounting for 51%-55% since 2000.
So what is the government spending this money on?
Unlike with receipts, where the government is spending its money has changed over time. The graph below shows government spending composition as a percentage of GDP since 1956:
The major trends in government spending are:
- Social security remains the largest component of government spending, accounting for 10.2% of GDP in 2023. This has remained the largest government expenditure since the mid-1960s, although its lead is quickly being narrowed by increased spending on healthcare.
- The government is spending more on healthcare. In the late 1950s the government spent only 2.8% of GDP on healthcare, but this has steadily risen over time, peaking at 10.5% during COVID, and now at record ex-COVID levels of 8.4% of GDP.
- The government is spending less on defense. In the late 1950s the government was spending almost 8% of GDP on defense, which has steadily shrunk over time and now sits at 2.3%. This has resulted in the newly-elected PM Kier Starmer’s commitment to increase defense spending to 2.5%.
- The most noticeable recent trend has been the large increase in the amount spent on debt interest. Last year the government spent almost as much on debt interest payments as on education. This debt interest is a result of the deficit.
How big is the deficit?
In the financial year 2023/24, government revenue (from the taxes we saw above) was £1.1 trillion. Government spending was £1.2 trillion in 2023/4, resulting in a deficit of £0.1 trillion (£121 billion).
Adding up all the receipts and all the spending each year gives an idea of how much the government needs to borrow each year to finance the difference (the deficit).
The chart below shows the difference between government receipts and spending since the early 1900s:
The two large spikes in spending denote the two world wars, and the most recent spike represents increased spending as a result of COVID. The green shaded area shows how much the government had to borrow each year to fund the deficit.
In 2023/4, the deficit was £121 billion, equivalent to 4.5% of GDP:
It’s not unusual for the government to borrow – the average post-war deficit has been 3% per year. Spending increased during and after COVID, as the government supported households and businesses with high energy prices and other cost of living pressures. While these temporary spending increases have abated, the graph does show, though, that borrowing is trending upwards over time.
What is the difference between the deficit and total debt?
We’ve seen that the deficit is the difference between government revenue and spending, usually measured over a single financial year.
The total amount of debt the government owes interest on, however, is the cumulative amount the government has borrowed over time. The total debt is therefore a much larger sum of money. At the end of 2023/24 public sector net debt was £2.6 trillion, or 99.8% of GDP:
Government debt has increased as a result of higher borrowing and slower economic growth – rising from 39.1% of GDP in 1980 up to today’s value of 99.8%.
100% of GDP, while a scary headline figure, is not unusual for countries to exceed. The graph below shows the debt to GDP ratios for the seven G7 countries:
Source: OBR, IMF
Looking on the positive side, the UK has the second-lowest debt to GDP ratio out of all G7 countries. On the other hand, since 2000 the UK has increased its debt to GDP ratio by 72% (28% to 100%), more than any other country apart from Japan.
Japan has a debt to GDP ratio of over 250% as a result of increased borrowing to attempt to stimulate the economy following the asset price bubble bursting in 1990, which led to a prolonged period of economic stagnation.
Who buys all this government debt?
UK government bonds are freely tradable, and are mostly held by overseas investors (31%), the Bank of England (28%), and insurance companies/pension funds (23%):
While households (individual investors), local governments, public companies, and private non-financial companies also hold gilts, their current holdings each rounded to zero percent of the total debt outstanding. The Bank of England is now a major holder of UK government bonds, thanks to the quantitative easing program launched in response to the 2008 crisis.
Quantitative easing (QE) occurs when a central bank buys government bonds – this keeps yields low and encourages spending in the economy. The BoE has now reversed its QE program, entering into what’s known as Quantitative Tightening (QT) where the bank either sells the government bonds it holds, or simply lets them mature without buying more. This is meant to keep yields high and reduce consumer spending to cool the economy.
What sorts of bonds has the government been issuing?
The government can either issue conventional bonds, or index-index bonds. Index-linked bonds have their repayments linked to inflation. If inflation is high, the issuer of the bond pays more in interest payments to the bond-holder.
The government can also choose the length of the bonds it issues. It can issue short-dated bonds which mature in the next few years, or it can issue longer-dated bonds which aren’t due to be repaid for many more years.
The chart below breaks down which types of bonds the government has issued over time:
Up until the 1970s, issuance was entirely conventional (non index-linked) bonds. Since then, up to 25% of each year’s issuance has been made up of index-linked bonds, although this has decreased in recent years. In the 2024 fiscal year, only 12% of total issuance was index-linked.
As the composition of issuance changes each year, the composition of the total debt pile also changes.
What makes up the government debt?
Although the government has been reducing the issuance of index-linked bonds, around a quarter of the total debt is still linked to inflation:
Within conventional bonds, the largest maturity type is long-dated bonds – those with a long time until maturity.
As index-linked bonds also have long maturities, the overall maturity length of the government debt is between 14 and 15 years:
How much does it cost the government to pay back this debt?
Interest payments on the government’s past borrowing are a large cost for the government. Last year, the government’s net debt interest spending was £102 billion, which is equivalent to 3.8% of GDP or 8.4% of the year’s total spending:
Source: OBR
This spike is largely because the interest paid on around the government’s inflation-linked bonds, which accelerated during 2022/23 as inflation rose rapidly. Interest rates also rose, further increasing spending on debt interest.
Summary
The UK’s financial landscape presents significant issues for the new government. With a substantial budget deficit financed through the sale of government bonds and public sector net debt reaching £2.6 trillion, the economic outlook remains challenging.
Social security and healthcare dominate government spending, while debt interest payments have surged, now rivalling education expenditures. Despite having the second-lowest debt-to-GDP ratio among G7 nations, the UK’s rapid debt increase since 2000 is concerning, as are the associated interest payments. Moving forwards, addressing these fiscal pressures while fostering economic growth will be a critical task for the government, requiring careful management from our new Labour government.