Sunday, September 04, 2005
Tax-and-spend faces a tough road ahead
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Gordon Brown returns this week in an uncomfortable situation. No, not the intensity of the Scottish sun, or the after-effects of his brief sojourn in Australia, but because his forecasts look so badly adrift.

The Treasury has often had fun at the expense of independent economists, its growth forecasts coming right as the year has gone on, leaving critics with egg on their faces. But, at the risk of joining them, that is not going to happen this time.

The latest monthly compilation of independent forecasts shows an average prediction for growth this year of 2.1%. The Bank of England has said growth will be roughly 2%. The range of independent forecasts runs from 1.3% to 2.8%. The most optimistic, in other words, is gloomier than the Treasury, which expects 3% to 3.5% growth.

Next year has not yet reached crisis proportions. The Treasury expects 2.5% to 3% growth, against an average of 2.3%. But many economists warn that high oil prices and falling consumer confidence — which dropped in August, according to new figures last week — could push growth below 2%.

If the chancellor is out on a limb on growth, he is also well away from the pack when it comes to his own borrowing. The Treasury expects public borrowing of £32 billion this year, 2005-6, dropping to £29 billion in 2006-7. The independent consensus is for £39 billion and £38 billion respectively. The gloomiest forecasters have £44 billion this year, £49 billion next.

To add insult to injury, the Office for National Statistics revealed that in 2004-5 Britain broke the European Union’s 3% budget-deficit limit for the second year running. The breaching is academic; we are out of the euro and, according to Kenneth Clarke, likely to remain so for his political lifetime (a safe bet). But pride is at stake. Brown has been used to lecturing members of the eurozone on their fiscal profligacy. The new numbers suggest the pot has been calling the kettle black.

That’s enough figures for now. The question is whether, faced with numbers like this, Brown will have no option but to bite the bullet and raise taxes. The arguments against are familiar ones, and have been rehearsed here before. If the cause of higher borrowing is weak growth, putting up taxes would make a bad situation worse. Lower-than- expected growth, meanwhile, removes the pressure in another way.

When the Treasury decided to change the timing of the economic cycle, moving its start from 1999 to 1997, it provided the chancellor with a “get out of jail free” card by making it much more likely that he would meet his golden rule — only borrow to fund public investment over the cycle. That assumed the cycle would end during 2006.

Weak growth suggests the current cycle can continue indefinitely, perhaps until Brown is safely in 10 Downing Street. Politically, he will not want to damage his progression from No11 to No10 by reminding voters of his habit of raising taxes.

But the chancellor cannot live with big budget deficits indefinitely. Independent groups, including the Institute for Fiscal Studies (IFS), Price Waterhouse Coopers (PWC) and the Ernst & Young Item club, agree that there is a structural, or permanent, budget deficit of £10 billion to £11 billion, which will have to be tackled.

That may yet mean tax rises. High oil prices, according to the IFS, are roughly neutral for the Exchequer — the improved corporate-tax take from oil companies being offset by the squeeze on non-oil-company profits. The postponement of rises in excise duty means the government’s petrol-tax take is not increasing in net terms.

Could Brown tap into high oil prices by taxing oil-company profits more heavily? Not to any great or permanent effect, according to the IFS. Nor is there much of a pot of gold from another tax change the Treasury has been reportedly looking at: the tax on development land proposed by Kate Barker in her review of housing. The serious money is in the big taxes — income tax, Vat and National Insurance. Given manifesto commitments, the only one of these that is a plausible runner is National Insurance.

Is there a better way? The important thing to understand about the government’s fiscal position is that it is not an accident arising from a combination of unfortunate events. When Brown and Tony Blair agreed a strategy of aggressively increasing public spending five years ago they let the genie out of the bottle.

A new analysis by John Hawksworth of PWC shows the extent of the pressures for higher government spending. These arise from an ageing population, the rising costs and demand for healthcare, and increased education spending, with staying-on rates at school rising as well as “early years” provision.

Other things being equal these factors will push up public spending to almost 42% of gross domestic product today to 50% by 2050, Hawksworth calculates.

One way of offsetting that would be to raise the employment rate. The government has a five-year “aspiration” of having 80% of 16 to 64- year-olds in work, compared with 73% now. Apart from the fact that this is a very challenging target, the PWC analysis suggests that only under a scenario where there is a much bigger increase — to 90% — will public spending be stabilised at present levels. That is not plausible, implying there will have to be big tax rises.

The alternative is for Brown to head off the problem with an eyewateringly tough spending round that not only sets tight limits for public expenditure in the medium term but also imposes longer-term restrictions. One way of doing the latter is to introduce the principle of “co-payment” for some public services, notably health. People, in other words, will be able to have non-core NHS services but only by meeting some of the cost themselves. But in his battles with the Blairites, Brown has opposed such ideas.

The chancellor has given himself nearly two years to rethink his spending strategy — the next round has to be concluded by the summer of 2007, delayed from 2006. He needs to use it to rediscover his lost reputation for prudence. Otherwise we will all suffer the consequences.

PS: Mervyn King will host a dinner this month to mark an important milestone in the Bank of England’s independence — 100 meetings of the monetary policy committee. The dinner, to which the governor has invited everybody who has served on the MPC since 1997, should feature some lively discussion on the future direction of monetary policy.

That is probably more than can be said for the 101st meeting, which will take place this week. Nobody expects a change in rates in either direction, and a 9-0 vote for no change is the most likely outcome.

The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, is split on both the short and long-term direction of rates. Two members, Patrick Minford and Peter Warburton, want a further cut from the present 4.5%. One, Tim Congdon, is worried about money-supply growth and wants an immediate hike back to 4.75%.

Of those who think unchanged rates are right this month, four — John Greenwood, David B Smith, Gordon Pepper and Kent Matthews — think the Bank will eventually have to reverse last month’s cut. One, Andrew Lilico, thinks base rate will have to stay at the present level indefinitely. Only one, Roger Bootle, is looking for further cuts, with the next one coming in November. I’m with him, if not necessarily on the timing. But persuading the majority, on the shadow and real MPCs, will need further evidence.

From The Sunday Times, September 4 2005

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