Wednesday, March 05, 2003
Riding the fiscal cycle
Posted by David Smith at 05:06 PM
Category: David Smith' s magazine articles

Of all the economic cycles that govern the ups and downs of business and of markets, none operates more dramatically than the fiscal cycle. Three years ago America was looking at budget surpluses stretching out in the indefinite future and Gordon Brown was criticised for being the policy equivalent of Lord Weinstock, building up a cash mountain while the country was crying out for more to be spent on essential public services and the creaking infrastructure.

Lord Weinstock’s cash mountain disappeared more quickly than you could say GEC, or Marconi, once his successors got hold of it. The chancellor, similarly, is finding that the same critics who attacked him for adopting an excessively cautious approach to the public finances are now admonishing him for his reckless abandon.

As he prepares for his spring budget, due this year in March, he has had to endure criticisms from several quarters. The Institute for Fiscal Studies (IFS) says he will eventually have to raise taxes by a further 11 billion to keep with his “golden” rule (only borrow to finance investment). The chancellor’s other rule, the “sustainable investment rule”, requires that government debt be kept below 40% of gross domestic product. With debt currently just over 30% of GDP, that is not under any threat at present.

It is not only the IFS that is worried about the public finances. The National Institute of Economic and Social Research estimates that the chancellor’s borrowing on his current budget (that is, excluding capital spending) will be a cumulative 35 billion between now and 2006-7. The Treasury, in contrast, expects a surplus of 5 billion over the same period. The difference, 40 billion, is significant, supporting the old adage that, a billion here, a billion there, and you’re soon talking about real numbers.

Even outside Britain, Brown’s public finances are running into criticism. The International Monetary Fund, having praised the chancellor’s stewardship, is now a little worried about the return to borrowing. The European Commission has warned that Britain’s budget deficit could soon rise to 3% of GDP. The significance of that number is that, were we inside the euro, the so-called stability and growth pact would require action to cut public spending or raise taxes, suggestions that are as welcome to the chancellor as a cold shower in a snowstorm.

The Treasury insists, as you would expect, that people are getting excited about very little. All over the world countries have seen budget surpluses turn to deficit, because of the global slowdown. Slower growth, which has turned to recession in some countries, means that tax revenues take a hit. Add in the need for extra government spending on, for example unemployment benefits, and it is not surprising that the public finances come under pressure.

But, the Treasury also insists, the appropriate response to this cyclical deterioration is not to put up taxes or cut spending on public services or the infrastructure. That would only make things worse. The right thing to do is to allow the “automatic stabilisers” to operate, to allow the budget deficit to increase during bad times, in the knowledge that there will be a return to surplus when the good times return.

Not only that, say officials, but the present situation, with projected public borrowing of 20 billion this year and 24 billion in 2003-4, is a pale shadow of the situation under the Tories in the first half of the 1990s, when the budget deficit hit 45 billion.

All that is true. The trouble is that, according to independent forecasters, this is not a problem that will disappear with the up phase of the cycle. Both the IFS and the National Institute fear that, as in the late 1980s and early 1990s, the government is overestimating the “normal” levels of tax revenues and that there will be a sizeable hole in the public finances even after the economy has recovered.

The IFS, for example, is worried on two main counts. It thinks the Treasury is being too optimistic about the taxes it will raise from financial companies, the City. Weak markets and low levels of merger and acquisition activity mean, it believes, that profits and hence taxes are likely to remain depressed for some time to come. The IFS also thinks the chancellor is unduly upbeat about corporation tax in general. The Treasury, it points out, is assuming a significantly higher level of revenues than the present system would have generated over the past 15 years.

The National Institute has similar worries. Part of the reason it expects bigger budget deficits than the Treasury over the next few years is that it thinks growth will be somewhat slower than the official forecasts. But this only accounts for a third of the difference. Most is due to independent weakness of tax revenues. If the chancellor is not careful, it warns, people may soon starting “unkind parallels” with his Tory predecessors who, like Mr Micawber, were always looking for the public finances to improve much more quickly than they did.

None of this is set in stone. Forecasting tax revenues is an imprecise art. Brown will certainly not want to act on these warnings in this budget, which will be neutral. Indeed, he will want to put off the day when he has to act as long as possible. So far he has managed to tie tax increases to specific increases in public spending, particularly on health. Putting up taxes just to mend the public finances is much less appealing.

From Professional Investor, March 2003

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