Budget spending plans will not fix deficit

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The Independent Online
Innocents might assume it would have been possible by now for economists to have reached agreement on a simple question of fact - is the fiscal stance likely to tighten or ease after last Tuesday's Budget? This still seems to be causing great, and needless, confusion. A more difficult question, on which reasonable people can genuinely disagree, is whether the state of the public finances remains sound in the wake of the package.

First, the question of fact. Mr Clarke himself described the measures in his Budget package as "neutral". However, some commentators have accused him of fiscal profligacy on the grounds that he has introduced a package that is looser than intended in the 1994 Budget. Meanwhile, others have pointed out that, with the PSBR still declining from one year to the next, the underlying fiscal stance is intended to tighten over the medium term. How are we to make sense of these conflicting claims?

The accompanying table shows how these different assessments can be reconciled. The new tax and spending measures introduced in the 1995 Budget are indeed roughly offsetting, or neutral in their impact. As lines one to three of the table show, the expenditure cuts announced in the Budget are approximately equal to the tax cuts, so there is little net impact on the PSBR as a result of the 1995 Budget, narrowly defined.

However, the changes to tax and spending plans announced in the 1995 Budget are by no means the only things that will affect the fiscal stance over the next few years. Much more important is what was assumed to be happening to the baseline for tax and spending, prior to the changes introduced in this Budget. If we put together these baseline changes - which, for example, incorporate tax increases of pounds 1bn per annum as a result of the over-indexation of fuel duties, and a sharp continuing decline in the share of public spending in gross domestic product - then we get a better idea of what may happen to the overall budgetary stance in the next few years.

Line five in the table shows what the Treasury is now projecting for the PSBR, taking account of all these factors. The planned PSBR declines from pounds 29bn in 1995/96 to pounds 22.4bn in 1996/97. In both cases these projections for the PSBR are considerably higher than was intended last year - by pounds 7.5bn and pounds 9.4bn respectively. It is these increases in the PSBR target relative to last year that have allowed some commentators to claim that the fiscal stance has been eased.

Relative to the extremely tight baseline for fiscal policy announced in the 1994 Budget, it is true that there has been some relaxation. But since the original 1994 plans involved such a large fiscal tightening from one year to the next, it has been possible to relax the stance a little, while still leaving some fiscal tightening in the new figures. Instead of saying that the 1995 Budget involves a relaxation of fiscal policy, it would be more accurate to say that it involves less tightening than planned last year - some residual tightening is left in place.

So how much tightening remains in the latest set of plans? Line seven shows that although the path for the PSBR is higher than intended last year, it nevertheless declines sharply from one year to the next - by pounds 6.9bn in 1995/96, pounds 6.6bn the following year and pounds 7.4bn a year later. Goldman Sachs estimates these planned reductions in the PSBR are substantially greater than those which would be implied by the automatic impact on the government accounts of above-trend growth in the economy. For example, for 1996/97, the planned change in the PSBR is pounds 6.6bn, of which pounds 4.2bn is explained by above-trend GDP growth. This means that the underlying fiscal stance, adjusted for the economic cycle, will tighten by pounds 2.4bn next year if the Government's plans are implemented. Similar calculations for 1997/98 show an underlying fiscal tightening of pounds 4.5bn.

What is the reason for this underlying fiscal tightening? Essentially, it stems from the fact that public spending is intended to be roughly flat in real terms over the next three years, so that the share of spending in GDP declines continuously. Of course, if the Government fails to hit its spending plans, the intended fiscal tightening may not take place. However, it seems irrefutable that, if everything goes according to plan, there will be some further fiscal tightening over each of the next two years.

Now the much more difficult question of whether policy is tight enough to leave the public finances in a sound condition. Here I find myself in the unfamiliar position of taking a more hawkish fiscal line than Sir Samuel Brittan, who is normally as rigorous on government borrowing as anyone can reasonably ask. Sir Samuel's Financial Times column last Thursday quite rightly complained about the City commentators who have described the 1995 Budget as a cut-and-run election package. I agree that it can hardly be called that. But I think Sir Samuel is too kind about the Treasury's medium-term fiscal arithmetic, which may not be quite as sound as he implies for two reasons.

First, virtually the entire decline in revenue since the last Budget (in fact pounds 8.5bn out of pounds 10bn) has been due to a lower tax take in nominal GDP, and not to lower GDP growth. To the extent that this drop in the tax take persists (and nobody knows whether it will), it will one day have to be replaced by higher taxes elsewhere.

Second, it is very optimistic to assume that the freeze in real public spending shown over the next three years will actually take place. Admittedly, the record of spending control in the past two years has been very good indeed, but the Government's future plans have an increasingly unrealistic air about them. We all know of companies in the private sector that try to cut expenses not by closing any businesses, but by temporarily squeezing wages below market rates, and by postponing capital spending. This is similar to what the Government is now doing. They are not eliminating any important government services, but are pretending that the costs of these services can endlessly be cut by efficiency improvements. I call that the Redwood fallacy.

The latest set of spending plans relies to an unhealthy extent on dubious restrictions on public sector pay, cuts in administrative costs which are unprecedented, and a build-up in the private finance initiative which the CBI considers implausible. But if these cuts in public spending cannot be delivered, then the PSBR could easily stay in the range of 3 to 4 per cent of GDP, which is quite simply too high. To my hopelessly unpolitical mind, it would have been much better to have waited until the spending cuts had actually been achieved before cutting the tax base yet again.

Sir Samuel has for years been a tireless campaigner against "funny money" in public finance. He has also argued against the Augustinian principle of "make me chaste but not yet". Unfortunately, the public spending path in the 1995 Budget could turn out to be Augustinian funny money - give me cuts, but not yet. If so, the problem of the British budget deficit will not have been solved.

The fiscal stance after the 1995 Budget

Financial year

1994-95 1995-96 1996-97 1997-98 1998-99

New measures in 1995 Budget (pounds bn)

Expenditure cuts - - 3.3 3.7 4.5

Tax cuts - - 3.1 4.6 4.8

Net impact on PSBR - - -0.2 0.9 0.3

PSBR projections (pounds bn)

1994 Budget 34.4 21.5 13.0 5.0 -1.0

1995 Budget 35.9 29.0 22.4 15.0 5.0

Difference 1.5 7.5 9.4 10.0 6.0

Intended fiscal stance (pounds bn)

Change in PSBR from previous year - -6.9 -6.6 -7.4 -10.0

Of which - activity effect* - - -4.2 -2.9 -4.7

- underlying fiscal tightening - - 2.4 4.5 4.3

Growth in real government spending

1994 Budget 1.4 -0.8 0.5 1.0 -

1995 Budget 1.2 0.2 -0.9 0.6 0.5