There are many reasons why the government may wish to reduce public expenditure, but the main reason is to reduce a budget deficit. A reduced budget deficit would result in a smaller , which means that the government will not have to borrow as much, so the national debt will be reduced. A drastic cut in government sending could result in a budget surplus, which would result in a PSBR.
Government spending can also be closely linked to inflation, because of the formula for aggregate demand; AD=C+I+G+X-M. An increase in aggregate demand can lead to inflation, so an increase in government spending, which will increase aggregate demand, can be inflationary. Therefore, if a government was pursuing a contractionary fiscal policy, they would want to reduce spending so as to reduce demand. Also, if a government wanted to reduce taxes, they would also have to cut spending so as to avoid encouraging inflation, because a reduction in tax rates will increase C in the aggregate demand equation, so without a cut in G, aggregate demand, and so inflation, will increase.
However, it could also be argued that a cut in government spending could be expansionary. This is because if the government cuts its expenditure, its PSBR will be reduced. This means that the government will not have to borrow as much as it would have before the spending cut, so the government will not have to sell as many bonds. This means that the government will not have to offer such high interest rates. Because interest rates have been cut, saving becomes less profitable, so investment will increase. An increase in investment will increase aggregate demand, which could help to bring the economy out of a recession.
The government may also forced to cut their spending because they cannot afford to maintain their current level of spending and because they cannot afford to borrow the extra money required. A situation like this could take place during a recession, when tax revenue is greatly reduced due to the increased number of unemployed people. Ideally, however, during a recession, the government would want to increase spending to try and increase aggregate demand and help bring the economy out of the recession. However, for the government to maintain a high level of spending, they will have to borrow a large amount of money. In order to encourage people to buy bonds, the government will have to offer high interest rates. However, because high interest rates encourage saving, investment will fall, which will reduce aggregate demand, which is the opposite of what the government is trying to achieve.
Also, the government may want to cut spending on a item which is no longer required, or which has greatly reduced demand. Conversely, the government may wish to reduce spending on a service which is costing them too much money. For example, various governments have made cutbacks on the services provided by the NHS, like dental care and eye care. These cutbacks were made because the NHS was costing a great deal of money, and the government could not afford to maintain its level of spending on the NHS.
When a government decides that they wish to cut government spending, for whatever reason, they must also decide how to cut spending, so that the effects that they are looking for actually take place.
At first glance, it appears that a reduction in state pensions would save the government much more money than a cut in defence spending, simply because the government spends so much more money on providing pensions. However, we must consider the implications of the suggested reductions.
A decrease in government spending on defence is likely to be counter-inflationary
Firstly, I will consider what effects will take place if the government cuts back on spending on state pensions. The amount spent on state pensions could be reduced in two ways; firstly, the government could reduce the amount paid to each pensioner, or secondly, they could reduce the number of people eligible for the state pension. However, both methods would have similar effects. The obvious effect of reducing the amount spent on state pensions is that pensioners will have less money to spend. This reduction in income will have far reaching effects.
Because Britain has an ageing population, OAP’s make up a significant amount of the population, so a reduction in their income will result in a reduction in aggregate demand. In areas with an older than average population, this reduction could result in businesses having to close, as there is no longer any demand for them. This means that the shop owners and their staff will become unemployed, which will mean that they will now have to claim unemployment benefit. If this phenomena is repeated nation-wide, the government will have to pay a significantly increased amount on benefits to the unemployed, which means that the government will not have succeeded in reducing its spending by much. However, the downwards multiplier effect continues, because those shop workers who have become unemployed will themselves have less money to spend, so other shop workers in their area may lose their jobs, due to the original shop workers having a lower income level. Therefore, we can see that a reduction in spending on state pensions could easily lead to regional unemployment.
However, there other effects that a reduction in the state pension will have. If pensioners have less money, their standard of living will fall, because they will be less able to afford food and household bills. Because the pensioners will have a lower standard of living, their health will get worse, so their demand for the NHS will be increased. This will again mean that the government will have to increase the amount that they spend due to a cut in pension spending.
However, as well as the negative effects mentioned above, a reduction in government spending on pensions would also have some positive benefits. For example, a reduction in government spending is counter-inflationary, so in a period of high inflation, this would please the government. Also, a reduction in government spending would allow the government to cut taxes, which would be popular with the electorate, although reducing pensions would not be popular, particularly with the old.
For this reason, a reduction in government spending would probably be more popular with the electorate for a number of reasons. Firstly, defence is perceived to be less important by many people than it used to be, now that the cold war is over. This is a view which has been shared by the government, as in recent years it has made large cutbacks in the armed forces. However, a reduction in spending on defence would have similar effects as a reduction in spending on pensions. A reduction in spending on both items would tend to have a downward multiplier effect. The mechanism that results from a reduction in pensions is detailed above, and a reduction in defence spending would work in the same way. If defence spending is cut, the servicemen that make up the army will either be made unemployed, or will have a reduction in their real income. This will result in shops in the vicinity of military barracks having reduced demand, which could result in unemployment and increased government spending on benefits to the unemployed. The shopkeepers and staff made unemployment would then have less income, so the shops that they would have shopped in could be forced to close so because of reduced demand. This cycle could be repeated continuously. However, because the number of military personnel is much smaller than the number of pensioners, the effects of a reduction in government spending are likely to be much smaller. Even when the effects on the workforce of the various manufactures involved in the military industry, such as British Aerospace and Marconi, are taken into account, the downwards multiplier effect is likely to be much smaller than the effects of a reduction in spending on pensions.
Like a cut in pension spending, a decrease in government spending on defence is likely to be counter-inflationary, although because fewer people are effected by it, the policy is likely to be less effective at countering inflation than cutting spending on pensions. However, the effectiveness cannot really be judged without knowing how large the cut was going to be.
