Government Cutbacks Why Are They Necessary and What Might They Do to the UK Economy - Research Paper Example

?Government cutbacks – why are they necessary and what might they do to the UK economy? Introduction The Office for National Statistics, United Kingdom, reported that the unemployment rate for the third last quarter of 2010-11 was 8%, 0.1% higher than the previous quarter. The total number of unemployed people had increased to 2.53 million, highest since 1994. The number of people applying for an unemployment allowance was at a staggering as 1.45 million. On the other hand in 2010 the UK government’s borrowing was at 148.9 billion pounds. In 2010 the government debt was at 1105.8 billion pounds, which was 76.1% of the GDP. Of that public sector net borrowing was 10.3 billion pounds in 2010 and the public sector net debt was at 58% of the total GDP (Economic Indicators, 2011). The growth predictions by IMF have been 1.75% in 2011 and the interest rates in 2011 have been at a record low at 0.5% (UK interest rate held at record low of 0.5%., 2011). The British Chancellor George Osborne has announced plans to reduce the government spending in public sector. Restrain will be enforced on government spending like benefits for the retired, higher education, flood defenses (Spending Review 2010: George Osborne wields the Axe., 2010). As part of the plan some surgery procedures will be restricted like cataract operation, some common orthopedic surgeries. Nursing homes for aged people will be closed and funds will be rationed for IVF procedure and obesity cures (Donnelly, L. ,2010). There will be other austerity measures like budget cuts for many facilities like libraries, trusts, theatres, counseling and advice centers on the country (Pubic Sector Cuts: Where will they Hit?, 2011). Prior to the budget the Chancellor had said that with this budget he wanted to take the country from a course of rescue to the course of reform. According to Cameroon the level of debt and the credit crunch are the main causes for the recession. So he preferred the strategy of monetary activities to control the recession. There was a tremendous opposition for the reduction in VAT by the Gordon Brown government, which led to a loss of revenue for the government facing a shortage of fund. On the contrary, the previous government relied on borrowing to increase government expenditure. According to them it would push the economy back on a path of growth. The Gordon Brown government strongly believed in adopting fiscal changes to tackle the recession. The key features announced by Gordon Brown were a 500 billion pound plan to save the banks and 21 billion pound of tax cuts and increase in government expenditure (Sparrow, 2009). Gordon Brown reduced the VAT by 2.5% from 17.5% to boost the household consumption. This reduced 12.5 billion pounds of tax revenue from the treasury annually. The other cuts announced by the then Chancellor Alistair Darling included extending the 120 billion pound annual rebate for the people paying tax at basic rate. Increases in the excise duty for vehicles were delayed. To discourage the foreign companies from shifting their businesses abroad tax was exempted on foreign dividends. Billions of pounds were assigned to construct roads, schools and housing projects. All these policies were framed keeping in mind the Keynesian theory of Aggregate Demand. The Aggregate Demand is the total demand for goods and services in the economy. The right hand side of the following equation gives it. Y + T = C(Y-T) + G + I(r, (Y-T)) + (X – M) Where, Y = Real Income T= Tax C(Y – T) = Consumption which is a function of real disposable income, i.e., difference between real Income and tax. G = Government Expenditure which Is Exogenous I = Investment which is a function of real disposable income and interest rate r = rate of interest which can be flexible (endogenous) or fixed (exogenous) X = Export Income M= Import Income Therefore, (X – M) = Balance of Payment. So if we consider the price level in the vertical axis and the national output in the horizontal axis and plot the aggregate demand curve, it will be downward sloping. According to the Keynesian theory in times of recession the income (Y) and employment of people remain low. Therefore the consumption and investment of the private sector, which depends on disposable income, remains low. Demand for goods remains low. As a result the income cannot grow and remains at a low level of equilibrium. The other two components of aggregate demand are the government expenditure, which is exogenous, and the balance of payment from trade. In a time of global crisis like the one faced by the British government the global markets remain weak, keeping the external demand low. Emphasis on the export industries will not give any yield in the short run. If the demand is not increased the country will continue to remain at a low level of equilibrium and the people will continue to have low income and employment. John Maynard Keynes, a renowned British economist prescribed that the government suffering from a low level of income has to increase its public expenditure exogenously to generate income and employment for its citizen. The increase in public expenditure will increase the income and employment generated in the economy. The extra income will lead to a growth in consumption. If the rate of interest remains unchanged or increases less proportionately then the household savings increase. This in turn will be converted to investment and further increase the national income. The increased income will again lead to a fresh round of increase in consumption and investment. In this way, the resultant rise in income will be more than the proportion of rise in government expenditure. This is called the multiplier effect and is given by dY/dG when all other variables remain constant. Similarly a fall in tax will lead to a rise in disposable income. This will lead to a rise in consumption and investment both of which are functions of disposable income and a multiplier effect will be triggered. The British fiscal policy of Gordon Brown was based on this theory (Monetary Policy - Inflation - Causes., n.d.; Mankiw, 2008; Rochon, 2008) However, the David Cameroon government felt that the rising public deficit and extra borrowing to increase government expenditure would lead to further financial fiasco due to the credit crunch (Adams, & Porter, 2008). The debt would eventually lead to fresh taxes in the future and will affect the long-term growth of the country. By reducing the government expenditure and the public debt the problem of credit crunch will be solved. However they preferred to maintain a low rate of interest to encourage investment. Concluding remarks The OECD’s secretary general has appreciated the policies of Osborne, though she warned that it would suppress the demand for a few years (Stewart, 2011). But renowned economists around the globe have widely criticized the measures. According to Paul Krugman, the austerity measures show a misdirected ‘bold’ move on the part of the government. The sudden fall in government expenditure would cost the country 490,000 jobs at a time when the private sector is incapacitated to create jobs (What The Experts Say., n.d.). According to economist Joseph Stiglitz the austerity measures would withdraw the stimulus at the most inappropriate time and weaken the country Bibliography 1. Donnelly, L. (July 24, 2010). Axe falls on NHS services, The Telegraph,available at: http://www.telegraph.co.uk/health/7908742/Axe-falls-on-NHS-services.html (accessed on April 12, 2011) 2. Economic Indicators. (2011). Office for National Statistics, available at: http://www.statistics.gov.uk/instantfigures.asp (accessed on April 12, 2011) 3. Mankiw, G. N. (2008). Brief Principles of Macroeconomics. New Delhi, India. Publisher: Cengage Learning. 4. Monetary Policy - Inflation - Causes. (n.d.). Bizled, available at: http://www.bized.co.uk/virtual/bank/economics/mpol/inflation/causes/theories1.htm (accessed on April 12, 2011) 5. Pubic Sector Cuts: Where will they Hit? (March 25, 2011).Guardian, available at: http://www.guardian.co.uk/society/2011/mar/25/public-sector-cuts-where-will-they-hit (accessed on April 12, 2011) 6. Sparrow, A. (January 5, 2009). 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Porter (April 15, 2008), David Cameroon attacks Gordon Brown over credit Credit Crunch, The Telegraph, available at: http://www.telegraph.co.uk/finance/2788251/David-Cameron-attacks-Gordon-Brown-over-credit-crunch.html (accessed on April 13, 2011) 12. Rochon, L. (2008), The Keynesian Muliplier, Place: New York, Publisher: Routledge. Read More