Brown's stance tougher than markets realise

`All the lessons of the 1950s - 1970s, which demonstrated that fiscal fine-tuning was at best a difficult art, seem to have been forgotten in the stampede towards the conventional wisdom that higher taxes are essential to manage demand in 1997'
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Gordon Brown's first Budget has been criticised in the City for failing to tighten the fiscal stance sufficiently, since most of the tax increases imposed - notably the windfall tax on the utilities and the dividend tax - will raise revenue without restraining demand. As far as it goes, this criticism is valid, since if we take the Budget package in isolation, the impact on short-run demand will be minimal.

But, as this column has been arguing for months, the Chancellor was never going to be able to control consumer demand this year through tax increases. This was never politically feasible, and probably not desirable. Nor did he ever suggest he was intending to undertake short-term fiscal interventionism. His objective was to rebalance the economy in the long term, not the day-after-tomorrow.

But where critics have really missed the point is that they have overlooked the fact there was already a substantial fiscal tightening built into the pre-Budget baseline arithmetic, taking effect each year over the medium term. When Gordon Brown agreed to stick to Ken Clarke's spending baseline for two years, he imposed on the system a fiscal tightening much bigger than anything anyone has recommended should take place in the Budget. Yet this is barely acknowledged in the public debate. In fact, because Mr Brown has left the spending totals unchanged in nominal terms while lifting inflation forecasts, the projected level of real spending next year is 1.5 per cent lower than Mr Clarke's baseline; the result is a tightening in the underlying fiscal stance of around 2 per cent of GDP in the next two years.

It is unclear whether those arguing for yet more fiscal agony are saying this planned tightening may not take place, or that it is insufficient, or that they have simply forgotten about it. In fact, the whole debate surrounding the Budget has, in many ways, been quite extraordinary - conducted in some kind of 1960s time warp, recalling the grand old days of Keynesian fine-tuning, with virtually no new frills attached. All the lessons of the 1950s - 1970s, which demonstrated that fiscal fine-tuning was at best a difficult art, seem to have been forgotten in the stampede towards the conventional wisdom that higher taxes are essential to manage demand in 1997.

It is worth restating why this conventional wisdom is not quite as self-evident as others believe. First, it is logically required, under the case for fiscal fine-tuning, that tax increases introduced today should be reversed later when consumers' expenditure has slowed down. Thus, those commentators who argue in favour of tax increases to slow the economy today should want tax cuts in a couple of years as the economy slows.

But temporary variations in taxation of this type do not change the household sector's estimates of its permanent income, and since consumption mainly depends on permanent rather than transitory income, such temporary tax changes may have little effect on the profile for aggregate demand. Empirical work that attempts to measure directly the impact of variations in taxation on demand has found it surprisingly difficult to detect any consistent impact at all.

Second, there is the question of flexibility. Even if fiscal fine-tuning can affect the timing of demand, it is by no means clear tax policy can be changed sufficiently rapidly, or sufficiently often, to make it a suitable instrument for fine-tuning in this manner. Interest rates can be changed 12 times a year, or more if necessary. Taxes can be changed but once a year, and with long lead times at that.

Past experience has demonstrated quite clearly that tax changes tend to occur much too late to have the desired impact on demand. Studies in the 1950s and 1960s commonly showed that fiscal policy made the economic cycle worse, because tax changes typically took effect only after the economy had naturally started to move in the opposite direction from that expected by the Treasury. There was clearly a risk that this would happen again, with the bulk of any effect of higher taxes on consumers expenditure coming next year, by which time the economy may already be slowing down.

Third, there is the question of scale. On Goldman Sachs' models, it would take at least a pounds 9bn consumer tax increase to reduce the upward pressure on base rates by 1 percentage point. In the Budget run-up, no one seemed to be arguing for anything remotely on this scale. In fact, there was a severe risk that small tax increases on the consumer would be said to obviate the need for any further base rate rises, leaving the overall policy tightening insufficient to slow demand.

For example, the CBI has argued for pounds 2bn tax increases in the Budget, claiming that this should replace base rate rises. But a pounds 2bn increase in income tax would reduce the upward pressure on base rates by only 0.25 per cent. Very few, if any, of the enthusiasts for consumer tax increases have been honest enough to ask for increases of a scale sufficient to make much difference to the interest rate path.

It is easy, in putting these arguments, to be accused of not caring about the overvaluation of the exchange rate, or about the temporary squeeze on exporters which this involves.

This accusation is simply absurd. Of course, it would be far better to avoid periods of exchange rate overvaluation if this were possible, and the point should be freely acknowledged. However, the problem inherited by the new Government is one of excess consumers' expenditure, generated by a period of overly lax monetary policy, and by the building society windfalls that probably could have been prevented by the previous chancellor, but were not. It so happens the problem has been made worse by the opposite set of circumstances in Germany - inadequate domestic demand, and cyclical downward pressure on interest rates.

In extricating the economy from this problem, it has always seemed likely that monetary policy would have to be the prime instrument of stabilisation since, for the reasons outlined above, fiscal policy would not be able to meet the challenge. The rise in sterling is an unwelcome consequence of the necessary monetary tightening. But it is better to control inflation than to control the exchange rate, as Nigel Lawson discovered in 1988.

Having failed in their quest for consumer tax increases in the Budget, the City critics have turned their attention to base rates, with several saying a half-point rise is likely this week. But what they may be overlooking is the extent of the deflationary drag which the exchange rate is now imparting on the economy.

If sterling stays at present levels, Goldman Sachs reckon this drag will be worth 2.3 per cent of GDP by the end of next year - much bigger than anything that could conceivably have been done in the Budget. Is this not enough to be going on with?