UK: PUBLIC SPENDING AND TAX ARE IN FOR TOUGH TREATMENT. - The Budget should hold few surprises given the state of public finances.

by David Smith.
Last Updated: 31 Aug 2010

The Budget should hold few surprises given the state of public finances.

Since becoming Chancellor of the Exchequer in May, Kenneth Clarke has played the straightest of orthodox bats on his plans for his first Budget. True, he has abolished the absurd and outdated tradition of Budget 'purdah', whereby Treasury ministers and officials were supposed to retreat behind their veils for nearly three months of the year. Otherwise, the first of the new unified (tax and public spending) Budgets, to be presented on November 30 remains steeped in much of the usual mystery. Clarke says that he intends to go right up to the wire, the last two or three weeks before Budget day, before making his final depositions.

We do, however, know the parameters of this year's Budget better than most. Norman Lamont's legacy was that Government's public spending decisions will have to be presented alongside any tax changes. The new unified Budget, of which this will be the first, is therefore closely modelled in style and timing on the old Autumn Statement. And, fortunately, rather less guesswork is needed on the spending side than is the case for taxation. The Cabinet agreed in July to stick with previously agreed spending plans, entailing a 1994-5 total (for the plans look forward to the coming financial year), known in the Treasury as the new control total. This total, we were assured back in the summer, will be £253.6 billion, not a penny more, nor a penny less.

Agreement on the overall public spending total leaves room, of course for changes in departmental allocations. I would be surprised if the distribution of spending between different government functions changes radically from those that made up the 1994-5 control total when it was first fixed last year.

We are not, in addition, completely in the dark on the taxation side. The current Chancellor inherited from Lamont plans to increase taxation by more than £6 billion in 1994-5, and by over £10 billion in 1995-6. Two of the ingredients of these tax increases - the imposition in two stages of value-added tax on domestic fuel and power and an increase from 9% to 10% in employees' National Insurance contributions - are well known. Of equal value in revenue-raising terms were the decisions to restrict mortgage interest relief and the married couple's allowance to a 20% rate of tax relief. Despite these substantial measures the consensus, both inside the Treasury and among independent economists, is that Clarke will need to add to the already-planned tax increases for 1994-5, possibly by up to £5 billion.

We know that some tax changes can be ruled out. The Government will not reverse the cuts in the basic rate of income tax of the 1980s, which brought the rate down to 25%. Nor will it tamper with the reduced rate 20% income tax band, introduced just before the April 1992 General Election and widened in the March 1993 Budget. Two other areas I believe to be sacrosanct are the top rate of income tax of 40% and the rate of corporation tax, now 33%. Why? Because to increase these tax rates would be in contradiction of the Conservatives' election promises (unlike VAT on fuel and power and higher NICs which were against the spirit but not the letter of the manifesto).

Clarke's options for raising taxes are, essentially, more of what has gone before. Since 1979 the Conservatives have exhibited a clear preference for reducing direct taxes on income, while increasing indirect taxes. Fuel and power were only one of several categories of goods and services which were zero-rated for VAT purposes. Politically, given the obvious impact on a vulnerable group in society - many of the country's pensioners - the Government went for the most difficult one first. Others include new construction, children's clothing and shoes, domestic water supplies, food, public transport, and books, newspapers and magazines. In the case of the latter, the decision by some newspapers to cut their prices during the summer has persuaded some Treasury officials that there is a chink of light in which to slot VAT. Any or all of the zero-rated areas could be picked off, possibly softened by the introduction of a reduced rate (5% or 8%) of VAT, but still providing a major chunk of the £5 billion.

There is also the strong possibility of further action to rein back mortgage interest relief, possibly by making it a time-limited relief or restricting it to first-time buyers. These are tricky political waters, although support for mortgage relief is probably weaker now than it has ever been.

There are two further aspects of the November Budget that I would like to touch on briefly. The first is its very timing. One of our best known retailers told me recently of the problems he had encountered when expanding in Continental Europe. Trade in the spring, summer and autumn had proceeded very nicely, so much so that he was convinced a bumper Christmas was in store. The outlets were stocked up accordingly and - nothing.

The British Christmas is unique. Some 50% to 60% of discretionary consumer spending (as opposed to spending on necessities) is in the run-up to Christmas, and, particularly in recent years, in the sales immediately following it. I wonder, therefore, whether a Budget in the middle of this key season for the economy is a good idea. Clearly, a tax-raising Budget has the potential for stopping some of this spending in its tracks - with major implications for economic recovery.

The second general point is whether the tax increases, both previously announced and expected in November, are necessary. Unfortunately this is not an easy question for economists to answer. To know for certain whether taxes need to be raised, one needs to know, not just the size of this year's public sector borrowing requirement but its trajectory over the next few years. If we concentrated purely on this year's £50 billion PSBR, we would conclude that taxes needed to go up enormously. But this year's borrowing requirement is telling us about the effects of the past, rather than the future.

The Nomura Research Institute, in an exercise reproduced in the chart (p17), shows the sensitivity of the PSBR to different assumptions, with growth averaging around 2.5% a year, and inflation 3%. The fiscal deficit, defined as the public sector financial balance, comes down but remains high at the end of the period. Case C, slower growth and lower inflation, is even worse, with any short-term progress in reducing the deficit quickly reversed. But in Case B, everything comes right. And Nomura's point is that the assumptions made in this case - inflation averaging nearer to 5% than 3%, and growth some 1% a year faster - are not particularly testing. They only imply, for example, a fall in unemployment to two million by 1998, although they also assume a pick-up in housing transactions to 'normal' levels. Even so, the deficit disappears, without any further action on the tax front.

My inclination is to believe that tax increases are necessary, not least because the Treasury has lost a major 1980s revenue source, that of North Sea oil. But the alternative view, that gloom about the deficit is excessive, should not be ignored. It would not be the first time that the Treasury has insisted on tough action which, in the fullness of time, proved unnecessary.

David Smith is economics editor of the Sunday Times.

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