UK: Lower interest rates would be the kindest Budget cut.

UK: Lower interest rates would be the kindest Budget cut. -

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

Recession Budgets are rare in Britain. The last one was in 1981. Since then Chancellors of the Exchequer have been able to put together their annual tax plans in relatively favourable circumstances. The result has been that recent Chancellors have been able to give free rein to their tax-reforming ambitions. Nigel Lawson's corporation tax reforms of 1984 and personal tax reforms of 1988 (when he established a single higher rate of income tax of 40%) will have repercussions for many years to come. So too, if more modestly, will John Major's Budget, the "savers' Budget", of a year ago.

Norman Lamont is not so fortunate. That the economy is in recession is now in no doubt. Indeed, one interesting aspect of the Budget will be the extent to which the Treasury revises its economic forecast to take in the realities of recession.

Recession Budgets used to be easy to predict. When the economy was growing too fast, and inflation and balance of payments problems were starting to emerge, the Budget was used to apply the brakes - through higher taxation, tighter hire purchase controls, etc. In the opposite situation of slow growth or economic decline, and rising unemployment, expansionary Budgets were very much the order of the day. The Chancellor would ease up on credit controls, ease taxation and (in his Autumn Statement) loosen the Government's grip on public spending.

The process was helped by the so-called "automatic stabilisers" - the tendency for taxation to increase faster and public spending at a slower rate in a boom, thereby reducing government borrowing, and vice versa in a recession.

The previous recession Budgets of this type were seen in the 1974-75 slump. When the first oil crisis sent the British economy downhill, the response of the then Labour government was to try and expand its way out of trouble.

The Conservative government which was elected in 1979 saw things very differently. The big problem with this sort of fine-tuning, advisers said, was that it usually did more damage than it corrected. This was because policy was and is subject to important time lags. Take the current situation, for example: it is clear that the economy as a whole embarked on the present recession in about the middle of last year. The earliest that the Treasury could act on the tax front would be March 1991. And it would be well into the second half of 1991 before the effects of those tax changes would start to have an impact on economic behaviour.

The Conservatives also saw tax policy as a means of establishing control over public sector borrowing, and of introducing tax reforms to assist the supply side of the economy. Touches on the economic tiller were to be reserved for monetary policy - and changes in interest rates in particular.

This was why the most recent recession Budget, in March 1981, differed from its predecessors. Instead of cutting taxes to boost the economy out of recession, Geoffrey Howe, then Chancellor, effectively increased them, by not raising personal tax allowances in line with inflation.

The spirit of 1981 still survives in the Treasury today although political constraints, and the fact that an election cannot be too far away, will prevent anything quite as austere as 10 years ago. But the analysis is much the same. The Treasury wants a Budget which will assist the process of cutting interest rates, and this means keeping the financial markets happy.

The additional complication this time, of course, is that the pound is in the European exchange rate mechanism (ERM). The House of Commons Treasury and Civil Service Committee has argued for the more active use of fiscal policy (in other words, a more aggressive use of tax cuts in recession) because of the constraints on interest rate changes caused by ERM membership. The Chancellor is, however, unsympathetic and safety-first will be his watchword.

The danger, clearly, is that a tight Budget will not bring about the desired response from the financial markets, and business will get the worst of both worlds - continued high interest rates and no help from the Budget. The Confederation of British Industry, in particular, is concerned that, with investment falling sharply this year, the absence of business tax reductions can only serve to deepen the gloom.

The CBI makes two important points. The first is that, with the consumer being the main culprit in the spending boom which led to the current difficulties, there is a case for shifting the tax burden from industry to individuals. This could be achieved by limiting the increase in personal tax allowances, and using the money saved to, for example, introduce more generous depreciation allowances against new investment. The Budget would still be a tight one, but it would be geared to maintaining business investment as we approach the post-1992 Single European Market, and limiting the effects of the recession on business. The organisation's second point is that industry has been the unintended victim of high inflation, which has led to a significantly higher corporate tax take than the Lawson reforms of 1984 intended.

I suspect that, in the highly political times in which we live, Mr Lamont will reserve any spare cash in the Budget kitty for vote-catching ideas. Even so, for both individuals and business, the best recovery hope is the one that is based on lower interest rates.

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