The difference between debt and deficit

In today’s Autumn Statement, George Osborne reported that the deficit was down by a quarter, but that the debt will not start to fall until 2016. Confused? Here’s our guide to the difference between the two

Is there a difference between debt and Deficit?

a: Oh yes. The words are not interchangeable. In macroeconomics, they mean very different things.

Q: How?

a: Well the debt is the total amount the UK owes to other nations, in other words its total level of borrowing.

Q: And the deficit?

a: The deficit is the annual budget overspend by the government i.e. the difference between what it collects in revenue (eg taxes) and what it spends on services. If a government brings in more in taxes than it spends, we call that a budget surplus.

Q: So it’s quite possible that, while the deficit falls, the debt actually increases.

a: Correct. In fact, it’s inevitable while there is any deficit at all. Think of a household budget that starts with a balance of zero. If expenditure exceeds revenue/income by £100 every month after a year, the household will be in £1,200 of debt.

If we then reduce the monthly deficit to £50 by either increasing income or reducing expenditure, the debt after two years will be £1,800 – it’s increased, just at a slower rate.

Q: So all we have to do to reduce the UK deficit is cut spending?

a: Sadly, managing a national budget is not as simple as managing a household budget. When you reduce public spending, you can also reduce national tax take – by putting public workers out of work, for example, and choking off growth in the economy. You also risk increasing national costs, through social security benefits, such as Job Seekers’ Allowance.

Why has the deficit become so big?

a: One key reason is that the recent recession caused a sharp slowdown in economic activity. This meant that the government’s tax receipts were lower than forecast – and will continue to be. So the government has a smaller pot of money to pay for public spending, forcing it to meet the shortfall by borrowing.

Q: How much of the current deficit was caused by the hundreds of billions of pounds the Labour government spent supporting UK banks during and after the banking crisis?

a: Without the banking crisis, with the government borrowing just over 1% of national income each year, government debt would have stayed below 40% of national income – and was forecast to fall gradually over time, according to the Institute for Fiscal Studies (IFS), an independent economic research organisation.

After the crisis debt would have exceeded national income by the end of the decade if the government had not altered policy, the IFS says.

But even without the mitigating factor of the financial crisis, the Labour government’s spending plans were unsustainable, according to the IFS. This is because spending levels were based on the assumption that unsustainably high levels of economic activity and tax revenues over the past decade were here for good.

AAT Comment offers news and opinion on the world of business and finance from the Association of Accounting Technicians.