Darling's fight to keep voters and the credit markets sweet

It's a big ask: how to convince the markets you're tough on the deficit, while staying in voters' good books. Sean O'Grady looks forward to the pre-Budget report

With its vital political timing, next week's pre-election pre-Budget report could be an eventful affair. The Chancellor, Alistair Darling seems unlikely to announce a further special fiscal boost of any size, despite signs that the recovery is late but some economists have begun to talk up the chances of some minor voter-friendly wheezes, such as a temporary income-tax rebate.

Many expect that Mr Darling will also take the opportunity to announce – or pre-announce – the sort of eye-catching measures that will help sharpen the Labour Party's message in the run-up to a general election. Moves on inheritance tax, income tax, VAT and capital gains tax have all been canvassed as ways for ministers to raise money and to reinforce the Government's differences with the Conservative programme. But the fragile state of the economy at present may militate towards postponement, if they are admitted at all.

Such measures may well make some difference to the public finances – as will sales of assets such as the Tote and, possibly for later on, the nationalised banks, as well as anticipated reductions in public spending plans. However, in broad economic terms, the extreme tightness of the public finances, the closeness of an election and the still-gloomy prospects for the economy seem set to conspire to prevent the Chancellor being able to announce anything too transformatory.

A downgrade in the economic forecast for this year seems an odds-on certainty. This will come despite yesterday's admission from the Office for National Statistics that they may have badly undercooked the economy's performance during the third quarter because of a radical underestimate of the health of the construction sector.

Even if the UK's GDP contraction is trimmed, as analysts expect, from 0.3 per cent to 0.1 per cent, against an initial estimate of a 0.4 per cent fall, that will still not be enough to save Mr Darling's Budget-time estimate that the economy would contract by 3.5 per cent over 2009: a drop nearer to 4.75 per cent seems on the cards, with a confident prediction that the economy will indeed return to growth by the year end, as Mr Darling has consistently maintained.

Next year, the Treasury's forecast for growth will be 1 to 1.5 per cent, broadly in line with the consensus. Further out, the Treasury seems set to be more bullish – with above-trend growth of 3 per cent or more over 2011 and 2012.

Many City economists will pour scorn on such optimism but the last Bank of England inflation report gives the Treasury plenty of covering fire for its optimism: the Bank suggests 4 per cent growth as a central path for the economy in 2011. Such buoyancy would certainly help Mr Darling make his figures add up.

But the fiscal deficit will remain the focus of attention on Wednesday. Treasury sources are hinting that the shortfall for this fiscal year will come in at only a little above the admittedly record-breaking £175bn estimated already. (In the 2008 PBR it was forecast to be £118bn, a figure thought shocking at the time). If they go ahead, the restoration in VAT to 17.5 percent on 1 January, the end of the stamp duty holiday, and the higher National Insurance and income tax bills for next year will help prevent the figure rising beyond £200bn, as somestill fear.

Yet it is the detail and speed of deficit reduction over the next parliament that seems set to be the "judge and jury" for Mr Darling. The Governor of the Bank of England, Mervyn King, said recently that the Government "does need a credible plan over the lifetime of a parliament to bring down very significantly the deficit, contingent upon the state of the economy. It must depend upon that but there has to be a plan of action that would explain what would be done". The "contingent" clause offers Mr Darling sensible flexibility: the "credible" line seems a concession that the sort of blind, panic cuts that some are urging would be politically unrealistic and might do more harm than good, given a hesitant recovery.

But the Governor's warning, in crude terms, means means that Mr King would be obliged to raise rates sooner than thought, and reverse quantitative easing – the £200bn cash injection into the economy – earlier if the Government failed to make such a credible plan stick. Hence the "Fiscal Responsibility Act" that will be outlined alongside the PBR, though cynics and sceptics dismiss its real importance. It promises to halve the deficit by 2014.

Whether that is enough to satisfy Mr King, the markets and the credit ratings agencies we will have to see but Mr Darling is understandably reluctant to be explicit about spending cuts in the run-up to polling day.

From his public utterances and briefings, Mr Darling seems set to reiterate a commitment to ringfence "front-line services" – but perhaps more narrowly defined. Thus the NHS or education budgets as a whole may no longer be sacrosanct, much to the discomfiture of spending ministers such as Ed Balls. Mr Darling is likely to offer guarantees on funding for patient care, classroom teaching and "beat" policing. International development and the Crossrail project also seem set to be offered dispensations from cuts. Local councils will not be so lucky; a 10 per cent slash in their budgets seems in the offing, a perhaps cynical way to shift blame to local politicians.

Still, Mr Darling can count himself lucky to be in the post, after the most turbulent chancellorship since the second world war, and an abortive palace coup against him by Mr Balls.

Should Mr Darling actually manage to help deliver Labour an historic fourth term – and Mr Brown a mandate in his own right – even in a precarious minority administration, he deserves the eternal thanks of his party, statues in his honour and the pick of posts after the election.

Will this Wednesday see the start of Labour's electoral revival as well as economic recovery?

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