When you buy UK government bonds (gilts), you’re lending money to the government.
As with all lending, it’s good to understand what the money is being used for and how the borrower plans to repay you.
In the book ‘Follow the Money’, Paul Johnson, Director of the IFS think tank, looks at how the UK government taxes us and spends the money.
This article isn’t personal advice. All investments, and any income from them can rise and fall in value, so you could get back less than you invest. If you’re not sure what’s right for you, ask for financial advice.
What is the UK government getting from taxes?
The government raised £910bn in taxes in 2022/23. Nearly two-thirds came from just three sources – income tax, national insurance contributions and VAT. And income tax alone counted for over a quarter of all revenues.
In 1799, William Pitt the Younger introduced income tax to help pay for the Napoleonic War. It was officially abolished after the victory at Waterloo. Robert Peel ‘temporarily’ brought it back 27 years later in 1842 – and it’s been with us ever since.
The taxes that most directly hit investors are capital gains tax (which raised £16bn) and inheritance tax (£7bn). Together this was less than 3% of the total raised. However, investors in company stocks also contributed through their share of the £66bn raised through corporation tax.
What is the UK government spending its money on?
The table below sets out the main areas of government spending.
UK government spending in 2022/23
£bn | % of total | |
|---|---|---|
Health and social care | 180 | 15 |
Local and devolved governments | 151 | 13 |
Pensions | 135 | 11 |
Benefits and tax credits | 108 | 9 |
Schools | 54 | 5 |
Further education* | 19 | 2 |
Other | 533 | 45 |
TOTAL | 1,180 | 100 |
*Including tuition fee loans.
When households plan their budget, they usually split their spending between essentials, like bills, and discretionary spending, like holidays. When times are tough, households can then cut back on their discretionary spending.
That isn’t an option for governments. All the big spending categories are essentials. And governments typically increase spending during economic downturns, to support the economy and meet the growing needs of the unemployed.
But one department has seen steady cuts over the last 75 years, helping balance growing needs elsewhere – defence.
During the Korean War in the 1950s, we spent a tenth of national income on our army, navy, and air force. Today it’s just two percent.
This peace dividend is clearly over.
What is happening to UK borrowing?
In the last tax year, the UK government borrowed £121bn. Its budget deficit (the difference between spending and the income received) was 4.4% of gross domestic product (GDP). That’s well over the 3% average of the five years before the pandemic. This took public sector debt to 98% of GDP.
This borrowing is nothing new. We’ve spent more than we have raised in 99 of the 123 years since the start of the 20th century.
Still, the cost of borrowing right now is high. At some point governments will look to rein in borrowing – perhaps in response to bond market turmoil, like with the Kwarteng/Truss budget.
So, what can they do?
How can the UK government balance the books?
Paul Johnson suggests lots of ways the system could be better.
But the story of universal credit highlights how difficult it is to bring about change.
The idea was to replace the range of different benefits for the unemployed, the sick, and the poor. The then Conservative and opposition leader Iain Duncan Smith came up with the idea in 2002. He was appointed Secretary of State for Work and Pensions in 2010 and made delivering universal credit his number one priority.
And yet a policy, originally meant to be completed by 2017, isn’t expected to be fully rolled out until the second half of this decade. A whole generation after the idea was first conceived.
With no obvious ways to cut spending, the alternative is higher taxes.
Johnson sees these as almost certain.
“Poor growth, an ageing population, an ever-voracious NHS, and little prospect of big spending cuts elsewhere are likely to make sure of that.”
He points out that our tax burden still isn’t especially high by western European standards.
Throughout history, the UK government has relied on its ability to borrow large sums of money quickly to respond to a crisis. Investors who provide this capital need to be confident they’ll be paid back – and that inflation won’t erode their returns.
Government bonds provide a secure source of income and a good diversifier to shares. But do keep an eye on the books. Follow the Money will help you understand why. And, despite the gloomy message, it’s an enjoyable read too.
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