A fiscal squeeze may be coming

The General Government sector is one of the five sectors that make up the domestic economy in national accounting frameworks. It includes central, state and local government and social security funds. Governments consume goods and services, including paying their employees; they also make investments (capital expenditure), transfer money to households (e.g., through social security payments) and other sectors (e.g., grants to businesses) and make payments of interest on government debt.

Some components of government expenditure feed directly into Gross Domestic Product (GDP), the headline measure of economic growth. Others do not – although they may contribute to other indicators such as household income or contribute indirectly to future growth (e.g., investment); but all categories of government expenditure are financed from governments’ budgets and captured in the national accounts measure of total government expenditure. A closer look at this measure can provide insights into the challenges currently facing governments across the OECD.

The Classification of the Functions of Government (COFOG) provides a breakdown of total government expenditure into ten functional categories of expenditure known as Divisions^.1 Since its development by the OECD in 1999, the COFOG has been adopted by countries around the world, with 34 OECD countries reporting expenditure by COFOG at present.

Figure 1 shows the breakdowns of total government expenditure for the five largest COFOG Divisions for OECD countries for which data was available in 2021 (with the other five grouped as ‘other’). Social protection, which includes pension and benefit payments to households, accounted for over one-third of total expenditure in 23 OECD countries, with the highest proportions in Chile, Finland, Luxembourg, Italy, France and Denmark. Health and education were also important in all countries.

Over the two decades to 2021, governments’ spending patterns changed. Figure 2 shows COFOG Divisions where spending increased or decreased significantly in relation to the total over this period. Public debt transactions, which is a Group within the Division ‘general public services’, is also included.

Most of the countries in the OECD for which data is available experienced increases in health and social protection spending as a proportion of total expenditure over this period, accompanied by decreases for education, defence and public debt transactions. It should be noted that these are relative changes in the share of total spending. In absolute terms, both total government spending and spending in most COFOG categories increased between 2000 and 2021, mainly due to inflation. 

Every country except Greece experienced an increase in the proportion of government spending on health over this period. The share of health spending in the United Kingdom, the United States, Korea, Netherlands, Denmark and Ireland increased by more than 5 percentage points (ppts). A majority of OECD countries also recorded an increase in the proportion spent on social protection, with the biggest increases (over 9 ppts) in Korea, Portugal and Iceland. Part of the reason for the increase in the shares of budgets allocated to health and social protection is population ageing. Across the OECD, the proportion of the population aged 65 or older increased from 12.8% in 2000 to 17.3% in 2020 (OECD, 2023).

On the other hand, over this period defence spending fell as a proportion of total government expenditure in 22 OECD countries. Notable exceptions to this trend were the three Baltic states: relative expenditure on defence increased by 2.7 ppts in Latvia, 1.7 ppts in Estonia and by 1.6 ppts in Lithuania. Many countries also saw relative decreases in education spending over this period.

The biggest decline in budget share during this period was for expenditure on public debt transactions. This category comprises interest payments and outlays for underwriting and floating government loans (UNSD, 2000). The decline occurred in all OECD countries for which data is available.² There was an unweighted average reduction of 4.2 ppts in the proportion of OECD countries’ budgets spent on this category, with the biggest reductions in Belgium (10.1 ppts), Greece (9.1 ppts) and Iceland (8.7 ppts). By 2021, spending on interest payments absorbed much less of OECD countries’ budgets than it had done two decades earlier.

A reduction in the share of government spending going to service public debt may be explained by a decline in the overall level of debt or by a decline in the rate of interest being charged by those lending to the government. Since 2000, most OECD countries have seen government debt increase in both absolute terms and as a proportion GDP (Figure 3). This has been driven by increases due to fiscal policy measures during the global financial crisis in 2008-09 and the COVID pandemic in 2020-21.

Therefore, the reduction in the share of government budgets spent on debt servicing cannot be explained by a decline in government debt. Instead, it has come from lower rates of interest on government debt. Due a variety of factors, most OECD governments have been able to issue new debt (borrow) at progressively lower interest rates, with rates hitting their lowest point for most countries in 2020. Figure 4 provides an illustration for G7 economies. The trends are similar for other OECD countries.

This analysis of indicators from the national accounts suggests that, in the first two decades of the 21st century, reductions in relative expenditure on debt service payments due to falling interest rates helped governments to increase the share allocated to health and social protection expenditure. However, recent developments may make this more difficult.

Figure 4 shows that since 2020 long-term interest rates for G7 countries, based on yields of 10-year (or similar) government bonds, have increased. This pattern is similar for all OECD countries, with the average interest rate increasing by 2.2 ppts between 2020 and 2022. How quickly long-term interest rates have risen in each country depends on how much new borrowing governments has been needed and the extent to which long-term government bonds are index-linked (with yields automatically adjusted for inflation).

The recent increase in long-term interest rates combined with the higher overall level of government debt (Figure 3) will require governments to devote more of their annual budgets to debt service payments in coming years. As a result, they will be faced with some tough choices. They will have to consider reducing spending in other areas, increasing current revenue (possibly through increased taxes) or taking on additional debt. A fiscal squeeze may be coming.

Notes

1. The purpose of COFOG is to “classify the purpose of transactions such as outlays on final consumption expenditure, intermediate consumption, gross capital formation and capital and current transfers, by general government” The Divisions of COFOG are: General public services; Defence; Public order and safety; Economic affairs; Environmental protection; Housing and community amenities; Health; Recreation, culture and religion; Education; and Social protection. For more information see (OECD, 2021) (UNSD, 2000).
2. The analysis in this section excludes Canada, Mexico, New Zealand, Türkiye, which do not report COFOG breakdowns; and Chile, Colombia, Costa Rica, Korea and the United States which have short time series or do not provide breakdowns for public debt transactions.