Sunday, August 26, 2018
As the budget defciit falls, Hammond's task is clear
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

For a chancellor there are few things more comforting than good news on the public finances. And the latest news, released a few days ago, was good. The downward momentum for the budget deficit established by George Osborne from 2010 has been maintained by Philip Hammond.

A budget surplus in July is not unusual but this July’s, of £2bn, was the best for 18 years. Borrowing – the deficit – in 2017-18 was £39.4bn, the lowest for 11 years, and the last pre-crisis year of 2006-7. Borrowing so far this fiscal year is the lowest for 16 years.

The Office for Budget Responsibility (OBR), the fiscal watchdog, is not given to hyperbole but it noted the “substantial year-on-year improvements in the deficit”. In celebration, the chancellor may have been inclined to add to booming alcohol duty revenues - - up 7.4% or nearly £300m this year compared with last – with a tincture or two of his own.

The question is what to with it. While all eyes may be on the European Union, a tax-cutting experiment is under way on the other side of the Atlantic. Donald Trump may have had other things to think about in the past few days but his aggressive cuts in corporate and personal taxes have provided a significant spur for America’s economy.

There is also the argument, first set out in this newspaper immediately after the EU referendum, that some of those aggressive tax cuts, specifically a cut in corporation tax to 10%, from 19% now, would boost investment and help maintain Britain’s attractiveness to inward investors during the current period of Brexit uncertainty. Hammond himself once talked in a German newspaper interview of adopting a different economic model for the UK. That was always said to be one of the EU’s fears.

Tax is one thing, spending another. The National Health Service has had its 70th birthday present, in the form of additional spending building up to more than £20bn a year by the early 2020s. Other departments, creaking under the strain of eight years of austerity, want presents too, and lots of them.

So how will all this go down at the Treasury, as the chancellor starts detailed preparations for his autumn budget? The watchword I think will be that, while the public finances are better, they are not yet out of the woods.

Government debt, at nearly £1.8 trillion (there are 11 noughts in that figure) is still rising and, while it has started to edge down relative to gross domestic product, it is still a high 84.3% of GDP. It has risen by £1.25 trillion in 10 years and, as reported here recently, is on a trajectory that could see it rise alarmingly from the early 2020s, mainly because of demographic factors.

As for the deficit, the OBR has been having a bad time with its borrowing forecasts in the past couple of years, overestimating the impact of slower growth on the public finances. Its November 2016 forecasts were for borrowing of £68.2bn in 2016-17, £59bn in 2017-18 and £46.5bn in 2018-19. This compares with outturns of £45.8bn and £39.4bn respectively for the first two years, and what looks like roughly £30bn this year.

The Treasury will gratefully grab this improvement relative to the forecast, which adds up to roughly £50bn, with both hands. But it is also aware that there has been significant slippage in the public finances compared with what was expected quite recently. So if we take the OBR’s projections a year earlier, in November 2015, a big gap is starting to emerge. 2016-17 was roughly right but the 2017-18 deficit was projected to be under £25bn, this year less than £5bn and next year, 2019-20, a budget surplus of more than £10bn. Some of that slippage reflects policy changes; most is due to slower growth.

I also detect in the Treasury’s approach no desire whatsoever to go down the Trump route. His tax cuts were launched at a time when the US budget deficit was around 3.5% of GDP. They will push it up to some 4% of GDP in the current tax year and to 4.6% in the following two years. Cutting taxes may have given the US economy a sugar rush but at the cost of increased borrowing and debt. As I say, there is little appetite in the Treasury to follow that route.

As for taking out some Brexit insurance by cutting corporation tax, making businesses reluctant to leave Britain and persuading others that they should come, this is not gaining much traction either. Faced with the bigger risks of Brexit and of a Jeremy Corbyn government – cutting business taxes probably does not bring in many votes - a big cut in corporation tax would have a substantial deadweight cost in lost revenue without much impact on investment.

When it comes to loosening the purse strings on spending, the chancellor gave cabinet colleagues an iconic “there’s no money left” warning after the NHS announcement. They will hope to do better than that in next year’s comprehensive spending review but can expect a tough negotiation. And after a week dominated by the risk of a Brexit no-deal, the chancellor knows that he may have to dig deep to deal with the consequences.

Indeed, Hammond will be diverted from his budget preparations in coming weeks by his efforts to prevent the lemmings in his party diving over the no-deal cliff-edge, and educating his cabinet colleagues, including the new Brexit secretary, of the economic effects. That was the context of his letter to the Treasury committee on Thursday and his efforts will not stop there. The battle is joined.

So has the improvement in the public finances had any impact? Yes. It has headed off, for Hammond, the need to come up with unpopular tax rises to pay for the NHS settlement. None of the suggestions doing the rounds for those tax rises made much political or economic sense, so this has been a welcome escape.

Is that it? There is a phrase etched in my memory, used by Gordon Brown when chancellor, which is “prudence for a purpose”. In his case the purpose was a little too much imprudence. There is also the strategy in part employed by Osborne, also when chancellor, which was to not want to have the public finances in too healthy a state in 2015 for fear of diminishing voters’ fears about a Labour victory. Whether that was deliberate or an ex-post rationalisation can be debated.

There are examples of chancellors who have been too prudent for their party’s and the economy’s own good. Roy Jenkins spent years telling people that his prudence after the 1967 devaluation did not cost Labour the 1970 election.
Hammond is probably right to be cautious now, given the uncertainties. But at some stage, long after most voters have forgotten about the financial crisis but before the next election, he will have to demonstrate that the sacrifices were worth it.

Assuming the next few difficult months can be negotiated, that will include some tax cuts, and the experience with corporation tax is that you can reduce rates and increase revenues at the same time, and it will include an eventual easing of the squeeze on spending. Hammond’s prudence has to be for a purpose or voters will conclude it was all for nothing.