Where does the government borrow money from? UK debt and deficit meaning - Liz Truss spending plan explained

UK energy bills plans coupled with tax cuts look set to increase government borrowing under the new Prime Minister

With a vast cost of living crisis and fears of a recession, public, business and political attention is centred on the state of the UK economy.

The state of the public finances has come to the fore countless times since the 2008 Financial Crisis as a result of Conservative Party messaging, austerity politics and huge public spending in the wake of Covid.

The UK government borrows money to fund public spending (image: Getty Images)

These policies will almost certainly require the government to increase the amount of money it borrows.

But where does the UK borrow money from - and what does borrowing mean?

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What does borrowing mean?

Every year, the government raises money through taxes which are usually set out in annual Parliamentary event the Budget.

It uses this money to fund public services, invest in infrastructure and pay for the welfare state, amongst other things.

If it spends more money than it raises through taxation and other income, it has to ‘borrow’ to cover the deficit - i.e. the gap between the money it has and the money it needs.

Government borrowing tends to be funded by the private sector (image: AFP/Getty Images)

Should a deficit repeatedly appear on the public’s balance sheet over a period of time, it becomes known as the national debt.

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While you will often hear politicians compare the nation’s finances to the budget of, say, a business or a household, they work in a different way.

For example, debt can be very long-term - as much as 55 years - and can on occasion be cheap, meaning a government will borrow more to pay off old debt.

The International Monetary Fund (IMF) describes it as “an important way for governments to finance investments in growth and development”.

Government spending is usually funded by a mix of taxation and borrowing (image: AFP/Getty images)

Running deficits and gaining debt can also be politically useful, as a government could become unpopular if it raises taxes too much.

And, if a recession occurs - an event which can reduce the amount of money taxation provides - a government is likely to increase borrowing to fund public services.

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Problems mainly arise if a country defaults on its debt, i.e. cannot or will not pay it back.

If this happens, it tends to mean it becomes more expensive to borrow and economic output is impacted.

Where does the UK borrow money from?

The money the UK borrows comes from the private sector, usually financial institutions like pension funds and banks.

It raises this cash from bonds - also known as gilts.

The Bank of England sometimes funds government borrowing through quantitative easing (image: AFP/Getty Images)

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These are basically promises to pay the lender money over a certain period of time, with the bulk of this cash repaid on the final date of the bond.

The payments before the end of the bond’s lifespan tend to consist of interest.

Overall, the private sector views these loans as a low-risk way of investing.

This is because they guarantee regular repayments for the investor/lender over what is often a long period of time.

But they do carry some risk, as inflation can wipe out interest if the bond is not index-linked.

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Likewise, at the government’s end, issuing bonds (i.e. borrowing) becomes more expensive if inflation is high as investors will want to make a return in exchange for their cash.

The index-linked bonds it issues are also likely to become more expensive when inflation is high.

According to Reuters, debt interest for such bonds rose by £19.4 billion pounds in June due to record inflation.

Sometimes, the Bank of England (the public body in charge of the UK’s currency) buys them through a process known as quantitative easing - essentially printing money - aimed at boosting spending and investment and therefore, growing UK economic output.

What do Liz Truss’s spending plans mean for borrowing?

We currently don’t know the exact details of how Liz Truss will tackle the cost of living crisis and the recession that is forecast.

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But in her pitch to Conservative members on the campaign trail, her Downing Street speech on 6 September and Prime Minister’s Questions on 7 September, we got an indication of her plans.

Ms Truss wants to cut taxes - particularly for businesses - to promote economic growth.

Ex-Chancellor Rishi Sunak has warned such a move would make inflation worse.

New Prime Minister Liz Truss wants to borrow more money to fuel public spending (image: Getty Images)

Her rumoured plan to help households cope with rocketing energy bills is expected to involve government intervention in the wholesale energy market that will essentially cap costs for suppliers.

Given how much wholesale energy prices fluctuate, the figure for how much it will cost to implement this policy is estimated to range between £110 billion to £130 billion.

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Director of the Institute for Fiscal Studies, Paul Johnson, has described it as a “terrible policy”.

“The problems with it are twofold,” he told The Times.

“It’s enormously expensive and a lot of money goes to people who don’t need it, and [secondly] if you’re holding prices constant what takes the strain is supply, so that increases the risk that you’ll end up with shortages.”

As the government will be generating less revenue through taxation - with cuts to corporation tax and national insurance in the offing - it all means the country will probably have to rely more on borrowing.

It marks a major shift away from previous Conservative administrations, which have pursued varying policies of ‘balancing the books’ - i.e. cutting the deficit and national debt - rather than shaking what they previously called the ‘magic money tree’.