UK: SMITH ON ECONOMICS - TAXING TIMES FOR THE CHANCELLOR.

UK: SMITH ON ECONOMICS - TAXING TIMES FOR THE CHANCELLOR. - Politics dictates that Kenneth Clarke cut taxes in the November budget; a huge PSBR suggests otherwise. If he tries to adopt a middle course, says David Smith, he could fall between two stools.

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Last Updated: 31 Aug 2010

Politics dictates that Kenneth Clarke cut taxes in the November budget; a huge PSBR suggests otherwise. If he tries to adopt a middle course, says David Smith, he could fall between two stools.

It gets nearer. Kenneth Clarke's high noon will come towards the end of November, on a Tuesday in late autumn. He has proved to be a formidable, if occasionally clumsy, tax-raiser. Now politics dictates that he has to be a clever tax-cutter too. Unfortunately, economics has something slightly different to say.

The run-up to the November 1995 budget began on the afternoon of the November 1994 budget, just after the Chancellor sat down. At that time he announced a sharp reduction in the public sector borrowing requirement, to £21.5 billion for the 1995-6 fiscal year, from £35 billion in 1994-5, with a further fall, to £13 billion, projected for 1996-7. At the same time, the economy was growing strongly, with GDP up by 4% in 1994 and plenty of forecasters expecting a repeat performance in 1995.

Treasury got its sums wrong

The consensus was that, allowing for Treasury caution in its borrowing projections, and a likely repeat of the Chancellor's success in lopping billions off the public spending plans, the only question was whether the economy would be growing too fast to allow risk-free tax cuts. And so the numbers built up - what price £10 billion of tax cuts spread over the 1995 and 1996 budgets, enough to cut the basic rate of income tax from 25% to 20% ahead of the general election?

Or, according to some excitable backbenchers, why not throw in the whole £10 billion of cuts in the November 1995 budget, just to allow them plenty of time to sink in with the electorate?

That was then, this is now. Far from being cautious in its borrowing projections, the Treasury was too optimistic last autumn. Its revised summer economic forecast was for a 1995-6 PSBR of £23.5 billion, falling to only £16 billion in 1996-7. And the new consensus is that these numbers look on the low side. At the same time, hopes of 4% growth in 1995 have disappeared under the weight of sluggish domestic demand, another delay in the hoped-for investment recovery, and a tailing-off of the export boom. Instead of 4% growth, the economy will be lucky to hit 3%.

Something has gone wrong with the projected miracle turnaround in the public finances, and it is easily stated. The ideal recovery from the point of view of generating sharply rising tax revenues was of the late-1980s variety. This was a recovery built on a consumer boom and strongly rising real incomes, neither of which has yet shown any sign of repeating itself during this upturn. Recoveries that are export-based and otherwise highly laudable have the drawback of not being great tax generators. At the same time, the magic combination for public spending control - faster-than-expected growth and lower-than-expected inflation - which was the story of 1993 and 1994 is not the plot for 1995.

Now, Conservative MPs are highly resourceful. So, with the prospect of 'easy' tax cuts apparently receding, they have shifted tack. The 92 group of MPs wants £5 billion to £10 billion to be cut from public spending in order to make room for what it sees as electorally-essential tax cuts.

Unfortunately, there is a difficulty here too. Governments, when they trim public spending, have generally only been able to do so as mid-term exercises, when they can afford to risk unpopularity. The present Government, of course, has passed the point of no return in this respect. Already its public spending plans assume no real growth in spending in the pre-election period. To satisfy party hawks would imply presiding over real cuts in spending during the run-up to polling day, with all the attendant dangers of disruption in schools, hospitals and a perception that the caring services are not being properly cared for. No modern government has done this. This one is likely to be no exception.

A three-way choice for Clarke

Clarke, therefore, has a three-way choice. He could eschew tax cuts entirely, and concentrate on restoring the public finances to health, further convincing those on the right of his party that he can never be their man.

The economic question to ask is whether, in the absence of a political imperative, the Chancellor would even be considering tax cuts. As the chart shows, the contrast with the period of the Lawson tax cuts of the late-1980s could not be more stark. Those reductions came against the backdrop of budget surpluses, or public sector debt repayments, not huge PSBRs.

The second - and most likely option - is some modest cuts: say, 1p off the basic rate in this year's budget, with a repeat performance in November 1996, together with some tinkering around the edges, at a total cost over two years of £4 billion to £5 billion. The trick here would be to present these cuts as a down-payment on a steady programme of reducing the tax burden, to be delivered as the public finances improve further. Clarke could even argue that this is no pre-election giveaway, but the measured actions of a responsible government.

A scorched-earth policy

The third possibility could be described as the scorched-earth option: the Chancellor would cut taxes dramatically, perhaps even by that £10 billion figure over two years, knowing that clearing up the subsequent fiscal mess would dominate, damagingly, Tony Blair's first couple of years as prime minister.

We shall see. My expectation would be that Clarke will try to steer a course between the clamour of his own backbenchers and the uncomfortable reality of a stubbornly high PSBR. The risk would be that of being caught between two stools - tax cuts that are not big enough to sway the electorate (which will take some swaying) but substantial enough to persuade the financial markets that there has been a relaxation of official efforts to keep inflation under control. In this case, Eddie George would have the backing of the markets in arguing for higher interest rates, which themselves would wipe out the political gains accruing from tax cuts. Who'd be a chancellor?

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