UK: A TALL ORDER FOR FUTURE GROWTH. - David Smith suspends disbelief to consider optimistic recovery forecasts as tax increases bite.

Last Updated: 31 Aug 2010

David Smith suspends disbelief to consider optimistic recovery forecasts as tax increases bite.

If there is one question that has been dominating discussion of the British economy, it is this: can the economy withstand the impact of the record peacetime tax increases introduced by the Chancellor of the Exchequer, Kenneth Clarke, and his predecessor, Norman Lamont?

The only definite answer one can give to this question is that we will know quite soon. It is not strictly accurate to say that we have yet to feel the impact of the tax measures announced in the two 1993 Budgets - the freeze on personal tax allowances announced by Lamont last March took effect immediately (and was repeated, for the 1994-5 financial year, by Clarke). But it is true that most of the burden of reducing the budget deficit through higher taxation begins this April.

The legacy of last year's two Budgets is that taxes will increase by more than £8 billion while public spending will be reduced, compared with previous plans, by over £3 billion. The combined effect is a fiscal tightening equivalent to 2% of GDP. Nor is this merely a temporary hit. In 1995-6, the cumulative tax increases are of the order of £15 billion.

From April, householders will begin to pay VAT, at an 8% rate, on domestic fuel bills. The majority of wage and salary earners will see their pay cheques reduced by 1% as a result of an increase in National Insurance contributions from 9% to 10%. Tax-paying home-buyers will note that their monthly mortgage payments are increasing, because of a reduction from 25% to 20% in the rate of tax relief on mortgage interest, and on the married couple's allowance. Further down the road will come a new 3% tax on insurance premiums and a new tax on airport departures. VAT on fuel will rise to 17.5% and the tax relief on mortgage interest will come down to 15%. Morgan Grenfell has calculated that the 1994-5 increases will slice 3% from the income of a married £30,000 earner who has a mortgage and drives a car (excise duties on petrol are pledged to rise by 5% a year in real terms).

Running the tax numbers through conventional economic models produces the result that, other things being equal, GDP this year will be reduced by between 1% and 1.5%. In other words, to achieve the Treasury's growth forecast of 2.5% with the tax increases, one would have to be confident that, in the absence of them, the economy would have grown by about 4%. This seems to ignore, among other things, the consumer caution and subdued housing market conditions that are legacies of the recession. But let me suspend disbelief for a moment and look at how this might happen.

The first line of argument is that exports and investment will take up the strain of supporting economic growth, the early stages of recovery having been mainly down to the efforts of the consumer. Alongside this, it is hoped that the impact of higher taxes on consumer spending will not be as great as the economic models suggest, because in an environment of low interest rates people will be prepared to run down their savings in order to maintain spending and, more importantly, they will increase borrowing. The combined effect of these actions will, it is hoped, offset the tax squeeze.

Those who share the Treasury's optimiism also point to what happened after Sir Geoffrey (now Lord) Howe's hairshirt Budget of 1981. Then, taxes were raised by the equivalent of 1.75% of GDP, even before the recovery had started. Nine successive years of growth followed, with the consumer in the driving seat.

There is a further, slightly obtuse argument to suggest that worries about the impact of higher taxes are overdone. People hate uncertainty. The mere presence of large budget deficits will be enough to persuade them that big tax increases are in store for the future (economists call this Ricardian equivalence, after the classical economist, David Ricardo). Far better, it is argued, to get the uncertainty out of the way and put the deficit on a convincing downward path, even if it means tax increases now. Thus, consumers may spend more in the light of known tax increases than they would faced with unknown hikes in the future.

All these arguments have something to be said for them. It was true that, in the 1980s, consumers became a near unstoppable force. But today people are emerging from recession older, wiser and saddled with debt. Comparisons with 1981 are facile. The Howe Budget came at the dawn of an era of financial liberalisation. Mortgage queues were no more, hire-purchase controls were abandoned and the credit card came into its own. These factors were enough to offset several tough Budgets.

As for the tax certainty argument - would that we had certainty. It is probable, after the Lamont-Clarke tax measures, that no further big tax hikes will be needed, particularly as we move into that phase of the political cycle where taxes traditionally fall rather than rise. The consumer cannot, however, be sure of this. The Chancellor has refused to rule out further increases.

It is important, when looking at the Government's tax strategy, to recognise that there are two policies at work, each designed to tackle a structural imbalance in the economy. The first is the strategy to tackle the structural component of the budget deficit (that part which will remain when cyclical factors have been ironed out). The second is, in effect, the Treasury's hidden agenda. If one accepts that Britain has a structural tendency to over-consume, in relation to exports and investment, then it is sensible to load tax increases on to consumers, while leaving exporters and investment companies (relatively) lightly taxed.

The risk with such a policy is that it will kill the goose - consumer spending - that has laid the golden egg of recovery. Last year it totalled around £400 billion, out of GDP of £630 billion. Exports and investment combined added up to some £250 billion. Thus, if the tax increases cut consumer spending by 1.5%, compared with what it would have been, then export and investment would need to increase by 2.5% just to offset it.

It is indeed a risk. I don't believe the tax increases will send us back into recession. But they will subdue growth, not just this year, but next year as well. My prediction of 2% growth this year sounds very modest. Set against the tax background, it is a minor miracle.

David Smith is economics editor of the Sunday Times.

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