UK: The Chancellor's big dilemma - picking the right tax option.

UK: The Chancellor's big dilemma - picking the right tax option. - The Budget question is one of tax - whether to increase it, and if so, where.

by David Smith economics editor of The Sunday Times.
Last Updated: 31 Aug 2010

The Budget question is one of tax - whether to increase it, and if so, where.

As harsh winter starts to give way to spring, most of us turn our attention to longer-term prospects. Not so, however, in the Treasury. Since before the first snowdrop tentatively poked its head above ground, the Treasury has had its mind fixed on that mid-March date when the Chancellor of the Exchequer delivers his Budget to the House of Commons.

The ritual has become well-established. In September, a very long list of possible tax changes circulates among selected ministers and officials in the Treasury and Inland Revenue. In November there is the Autumn Statement, setting out the public expenditure side of the Government's fiscal policy. In early January, Treasury ministers and officials gather to decide on Budget priorities. Then these priorities are put through the official mill. The finely honed set of proposals that emerge in March are the result.

This year's Budget is of particular interest, for two reasons. The first is that it will be unveiled against the backdrop of the worst fiscal position faced by any government since Labour's International Monetary Fund crisis of 1976.

Secondly, this Budget will be the last of what is a very British tradition. The next Budget after this one will come, not in a year's time, but in December, and it will be combined with the public spending announcements that have, until now, formed the basis of the Autumn Statement. Out goes the March Budget, in comes the unified tax and public expenditure statement.

The Chancellor did, of course, give us a flavour of the new approach last November, by including tax changes in the Autumn Statement. He also gave notice of some tax increases that we can guarantee will be in the March Budget. The £750 million or so cost of getting rid of the 5% special car tax (a purchase tax levied, in addition to VAT, on the wholesale price of new cars) will, he told us, be clawed back in the form of higher motoring taxes.

The Autumn Statement was also, however, candid in what it told us about the state of public finances. On the Treasury's projections, the public sector borrowing requirement is heading for £44 billion, or 7% of gross domestic product in 1993-4, after £37 billion, or just over 6% of GDP in 1992-3. Excluding privatisation proceeds, the 1993-4 official projection is £49.5 billion, or 7.75% of GDP.

If the Treasury is correct in its forecast of 1% GDP growth for 1993, then the 1993-4 PSBR will not represent the peak during the present cycle. Goldman Sachs, to take an example, predict a PSBR, excluding privatisation, of £60 billion for 1993/4. Then, if the economy's growth returns to trend, the borrowing requirement is predicted to rise to about £64 billion in 1994-5 and stay there for the following two years. On a low growth scenario - of about 1.5% a year - the PSBR excluding privatisation goes on rising, reaching nearly £80 billion, or 11% of GDP, by 1996-7. Move over Italy. Remember that, under the Maastricht convergence criteria, countries were expected to aim for public sector deficits of no more than 3% of GDP.

We should be wary of projections which point to a borrowing requirement that rises indefinitely into the future. For one thing, some forecasters in the late l980s were predicting that the public sector debt repayments then occurring would see the National Debt paid off by the mid-1990s. Similarly, however, we should not ignore the dangers of the present situation. Even a £40-billion annual PSBR will produce a sharp rise in debt interest, so that tax revenues have to be that much more buoyant, and public expenditure much more stringent, just to stand still. It is now plain that some of the tax harvest accruing to the Exchequer in the Lawson/Thatcher years represented a one-off shift. International companies took advantage of low corporation tax rates in Britain, alongside the phased reduction in capital allowances, to declare profits in Britain.

The Chancellor's key Budget decision, therefore, has to be based on the Treasury's answer to the question: is the tax base large enough to support public spending over the medium and long-term? If not, then either taxes have to be increased or public spending cut and such cuts are difficult. Once the Government's manifesto commitments on health, pensions and other social security payments are allowed for, there is relatively little to cut.

The Budget question is, however, essentially one of tax. Income tax increases would appear to be out of the question. Before the election John Major promised a gradual widening of the 20% reduced rate tax band so that, ultimately, it would replace the 25% basic rate of tax. The Treasury was noticeably more cautious. But even Treasury hardliners would find it difficult to reverse the basic and higher rate reductions of the 1980s.

This leaves VAT and National Insurance contributions. On VAT, two routes are possible: widening the coverage and increasing the rate. The latter, given the sensitivity of zero-rated status for food, children's clothing and footwear, domestic fuel consumption and books, may be an easier course than the former. A 20% VAT rate would bring in an extra £5 billion a year. But, at a time when the Government has lost its ERM anchor, would risk damaging knock-on effects on pay-bargaining. Higher NICs would be equivalent, in incentive and other effects, to a rise in income tax, and hard for Tories to defend.

The Chancellor's problems, as he frames the final spring Budget, are substantial. The new system of unified tax and public spending statements could, I fear, add to those difficulties.

When the Armstrong Committee proposed "green" Budgets more than 10 years ago, the idea was eminently sensible. The green Budget would be far enough in advance of the next financial year to allow full discussion by interested parties prior to their introduction. The Treasury is changing its timing but the nature of Budgets will remain the same. Instead of getting a fully-worked and final set of tax proposals in March, we will get them in December. And the Treasury is losing the flexibility of having two bites at the fiscal policy cherry - a flexibility that has been very useful in the past. One can see supplementary Budgets, mini-Budgets, coming back into fashion.

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