Business Analysis: What to expect from next week's pre-Budget report

Chancellor to insist public finances are still on track as Labour prepares for election

With just 23 weeks until a 5 May 2005 election, if the latest reports are to be believed, next week's pre-Budget report will attract much more attention than normal.

Gordon Brown will want to keep his pre-electioneering powder dry for a final Budget before polling day. But there is always room for surprises - and the Chancellor is prone to using his grand-standing Budget speeches to pull rabbits out of hats.

Public finances

While the chorus of siren voices warning of a "black hole" in the public finances grows deafening, the Chancellor is likely to stand firm and insist he will meet his fiscal rules. This self-imposed test dictates the Government must spend no more on day-to-day spending than it raises in taxes, averaged over the economic cycle.

In March Mr Brown said he would meet the test with 0.1 per cent of GDP, or £11bn, to spare - a tiny margin compared with the £3,000bn of public money spent over the seven years of the cycle between 1999 and 2006. In March he assumed the Treasury would rack up "current spending deficits" of £11bn for 2004/5 and £5bn for 2005/6.

Simon Rubinsohn, the chief economist at Gerrard fund managers, says: "He will probably revise up the projected deficits for both this year and next but still argue that he remains just within his self-imposed target."

The matter is confused by the way the Government assesses the rule. It measures surpluses and deficits as a percentage of GDP rather than a bald number, flattering early surpluses but underplaying recent deficits.

Whatever the rights and wrongs of that analysis, it may come to haunt the Chancellor as he starts the next cycle in exactly the opposite position.

Economic forecasts

As the Institute of Directors puts it in its submission: "This as good as it gets in the current economic cycle."

Growth is likely to hit 3.2 per cent this year, the best since the peak of 3.9 per cent in 2000 and comfortably within the Chancellor's 3.0 to 3.5 per cent forecast range that was once derided as ridiculously ambitious. The City is still sceptical about the 3.0 to 3.5 per cent forecast for 2005. The average prediction in the Square Mile is for 2.5 per cent next year.

The Government's forecast is based on an upbeat forecast for three keys drivers of economic growth: household spending, investment and exports. The 2004 Budget revised up all three with household spending growing by 3.0 to 3.5 per cent, investment up as much as 7 per cent and exports growing by 7.25 per cent. On all fronts the City is sceptical. Missing the forecasts would have no fiscal impact but would leave egg on his face. However as City analysts have found to their embarrassment, the Chancellor has a pretty good forecasting record.

Measures for enterprise

The Chancellor has repeatedly said the PBR will aim to foster enterprise and build up the UK's skills base to head off the challenge from low-wage countries such as China and India.

"In the coming pre-Budget Report we will make it our business to examine and remove the tax and regulatory barriers to enterprise," he told an audience of entrepreneurs last week. In particular he will tackle the red tape that prevents universities from converting research ideas into commercial applications. He is also likely to unveil incentives to help start-up business access finance.

Ernst & Young, the accountancy firm, is looking for reform of the enterprise investment scheme to make it more useable. It says many investors who could have qualified were unable to navigate through the scheme.

Property taxes

The Chancellor has raised billions of pounds with four successive hikes in the tax on moving home but has left it alone for some time. With house prices now falling this appears to have been a wise move. There is, however, growing concern the current system is outdated as it has failed to keep pace with the huge surge in prices over the past decade.

The trigger point has been set at £60,000 since 1993 while the last review before that was in 1984. With the average price of a home now exceeding £100,000, the threshold means stamp duty is now a catch-all tax. There is also criticism of the sudden jump from 1 to 3 per cent at £250,000, which means that a £250,000 sale incurs a £2,500 charge but a £251,000 sale attracts a £7,530 tax. There is a similar jump from 3 to 4 per cent at £500,000.

Property experts believe it would be possible to carry out a fiscally neutral reform by creating staggered rates and applying higher rates to the difference between the bands rather than to the entire value. MacIntyre Hudson, an accountancy firm, goes further giving odds of 6/4 on a set of brand new duty bands for high-value properties.

It said the 4 per cent band, intended to hit the super-rich, now affects the typical suburban family home. It predicts a 4 per cent rate at £750,000 with a new rate of 5 per cent from £1m and 6 per cent above £1.5m.

Elsewhere the industry is expecting little progress on the proposal for real estate investment trusts (Reits). Reits would offer tax breaks to encourage people to invest in property. Since Reits need legislation they are unlikely to find space in the Government's programme until late 2005 at the earliest.

Inheritance tax

In a similar vein to reform on stamp duty, the Chancellor might be tempted to announce an overhaul of inheritance tax.

In a move that could steal yet more of the Conservatives' clothes he could raise the threshold from £263,000 to about £300,000 to take account of the surge in house prices that has left hundreds of thousands of estates theoretically within its grasp. He could make this fiscally neutral - i.e. not a cost to the Treasury - by also introducing a higher rate of tax on more valuable estates. MacIntyre Hudson is forecasting a higher rate of 50 per cent for estates valued at more than £1.5m.

EU laws

A series of judgements by the European Court of Justice has raised a number of issues over the UK tax system that accountants hope will be resolved in the PBR. The decisions affect key areas where the UK tax system treated differently transactions within the UK and between different EU states.

Heading the list is transfer pricing, where rules governing transactions between subsidiary companies in different EU states must also apply to intra-UK transactions. While this raises little or no revenue for the Treasury, it creates labyrinthine compliance rules whose cost businesses must bear. Tax experts are looking for further clarification of how it is to be enforced.

However it has also set a precedent that the UK will enact change demanded by the ECJ rather than seek action by the European Commission. A recent decision pressures the UK to change the law on tax treatment of dividends to allow a tax credit on overseas dividends.

Sin taxes

In the Budget Mr Brown announced plans to tackle spirits smuggling by insisting on a new regime of bottle stamping to help crack down on evasion.

The move prompted outrage from the industry, which had submitted copious reports and held meetings with the Treasury. The Gin and Vodka Association has warned the move could add 43p to a bottle of spirits unless the extra costs were absorbed by the distillers. The industry, which failed to persuade the Chancellor to adopt a different approach, has suggested a number of ways the scheme could be implemented at a lower cost.

While levels of so-called "sin taxes" - alcohol, tobacco and gambling - are only altered at Budget time, the casino industry is anxious for any news about possible tax levels for the new super-casinos.

Although the Treasury has given no guidance on the new rate of tax, the Department for Culture, Media and Sport is said to have hinted at a tax on gross profits of 15 to 20 per cent. This would replace a banded duty regime of between 2.5 per cent and 40 per cent of the gross gaming yield.

At the other end of the scale MacIntyre Hudson puts odds of 2-1 that Mr Brown will boost the Government's public health crusade by exempting free gym membership offered by employers as a benefit in kind.

Previously announced

The Chancellor has already announced three measures to take effect next year that, in time-honoured fashion, he may be tempted to announce again.

Existing exemptions for employer-provided childcare will be replaced by provisions that widen the scope of tax relief. The Government has also indicated further measures to help with childcare that could form part of the PBR. And it is setting up Child Trust Funds for children born after 1 September 2002. Plus a simplification of the tax regime for pensions takes effect from next April.