Sunday, December 06, 2009
Darling's balancing act: cut deficit or win votes
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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Long years of experience have taught me that nothing dates so quickly as eve-of-budget pieces. Tens of thousands of man-hours go into predictions that a few days later are overtaken by the event itself.

So, having written on this week’s pre-budget report (PBR) last weekend, let me just race through a few quick points before moving on to a bigger issue.

On tax, two things have dominated the build-up. One is that Alistair Darling will extend the temporary Vat cut to give the recovery time to gather strength. You can never say never but I would be gobsmacked if that were to happen, having been assured by everybody that it will not. So we should expect Vat to rise from 15% to 17.5% on January 1.

The second area of speculation is that this will be a “squeeze the rich” PBR, intended to reinforce political differences between Labour and the Conservatives and put a bit more oomph behind Gordon Brown’s declaration of class war last week.

On this, as on so many things, the chancellor is walking a tightrope. He will not, I think, want to raise capital gains tax, despite the gap between its 18% rate and the new 50% top rate of income tax.

Darling’s big reform before the crisis was to simplify capital gains tax to 18%, something that led to a small storm of protest from entrepreneurs. So I would be surprised if he were to raise it. Other ways will be found to clamp down on bankers who arrange to get their bonuses paid as capital rather than income, to minimise tax.

On the other hand, it would be very odd, given the politics, if the planned increase in April in the inheritance tax threshold from £325,000 to £350,000 (double that for couples). There may be a little tinkering around the new 50% rate but it is hard to see Darling as a modern-day Denis Healey, squeezing the rich until the pips squeak with even higher rates of income tax. The chancellor, after all, has said he would like to reverse the rise to 50%.

The bigger issue is whether the markets and the rating agencies will be convinced by his commitment to reduce Britain’s enormous budget deficit. The bad news is that the numbers Darling will present this week will show that deficit even more enormous, though only by a few billion on top of the existing £175 billion projection.

Britain’s flexible job market has been good at preventing a bigger rise in unemployment but the effect of wage freezes and cuts and shorter working weeks has been to cut the income tax and National Insurance take more sharply than expected.

The good news is that it will be downhill all the way from here for the budget deficit, if the Treasury is right, 2009-10 marking a peak that will be followed by a halving - at least - of the deficit by 2013-14.

Will that, and the fact that these reductions will be enshrined in the new Fiscal Responsibility Bill, convince doubters? Treasury insiders think they should be convinced and that Darling, in setting out “frontline” areas of spending to be protected in the coming squeeze, will in effect be saying that other areas are fair game. Wage and working-hour sacrifices by the private sector will have to be matched by the public sector, though probably not with a blanket public sector pay freeze.

The markets have two fears. The first is that even a government elected with a decent majority will not be strong enough to take the tough and unpopular action needed to get the deficit down. The second is that the outcome of next year’s election will be a hung parliament, followed by many months of dithering and delay.

Morgan Stanley made headlines last week by warning of the danger, though I’m not sure the investment bank’s reputation was well-served by that warning.

Tucked away in its Strategy Euroletter, were three “potential” surprises for 2010, were “the dollar may strengthen” and “the surprise sector trade could be pharma”. And, oh yes, set out in just four paragraphs, Britain could have a major fiscal crisis, combined with a sterling crisis, but “UK equities may benefit”. I expect at least a 40-page report for something as big as a full-blown UK fiscal crisis.

Morgan Stanley was, however briefly, giving voice to a widespread fear in the City. How serious is the danger of one of those fears, a hung parliament?

Hung parliaments are rare but are more likely than they used to be, notwithstanding the 13-point Tory lead in today's Sunday Times-YouGov poll. Peter Kellner, president of YouGov, the pollster, points out that in 1959 only seven out of 630 MPs were neither Labour nor Conservative. In 2005, in only a slightly larger parliament, that total was 92.

To get an outright majority, one of the two main parties has to beat both its opponent and this large rump of other parties. Not only that but the task facing David Cameron’s Conservatives - increasing their MPs by more than 130, or nearly 70% (just to get a slim majority) - is a formidable one.

That said, hung parliaments need not be a disaster. The largest party can form a minority government or enter a coalition. The toughest squeeze on public spending in the 20th century, the Geddes axe of the 1920s, was instituted by a Liberal-led coalition government. Currently, some of the toughest measures to cut the budget deficit are proposed by the Liberal Democrats.

There will be more to be said on this in the coming months. Will Darling do enough this week to convince the markets that he is serious about deficit reduction and preserving Britain’s AAA rating?

I am not sure. The tightrope he is walking is between honesty on the public finances and not scuppering Labour’s electoral hopes. It is alsof trying to engender optimism while stressing the fragility of recovery. Recent events in Dubai, the German government’s concerns about lending to “Mittelstand” businesses and the Bank of Japan’s sudden decision to lend trillions of yen to its banks underline that fragility.

One suggestion for him comes from Oxford University’s Centre for Business Taxation. Professors Mike Devereux and Clemens Fuest suggest an announcement now to increase Vat in 2012, by enough to raise 1.5% of gross domestic product in additional revenue.

This would require pushing the main rate of Vat up to 21% or so, or slightly less if the Vat base was widened. The pre-announcement would be a strong signal to the markets and rating agencies, while not getting in the way of growth during the recovery phase.

Will it happen? Politics would suggest it is a policy civil servants would describe as “brave”. The risk is that without something brave, the markets will continue to fear the worst over the next few months.

PS The pre-budget report is not the only event this week. The day after, if it chooses to do so, the Bank of England’s monetary policy committee (MPC) could deliver a critical verdict on the chancellor’s efforts. One member of the shadow MPC, which meets under the auspices of the Institute of Economic Affairs, thinks it should do so. Peter Warburton wants an immediate rise in Bank rate to 1%.

That is highly unlikely but, just as the European Central Bank was interpreted by analysts to be nudging towards an exit strategy, so the shadow MPC’s thoughts are moving in that direction.

While some members want more quantitative easing, several think enough is enough. A similar debate has been taking place on the actual committee. As for interest rates, the debate will soon turn to when the Bank will consider it safe to start raising them. Though that is several months away, it will happen. The hope is that when it does, it will be a sign of confidence in the recovery.

From The Sunday Times, December 6 2009