Chancellor's task: a Budget to control consumption

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If the Chancellor had only to worry about the immediate economic situation, his task in the Budget tomorrow would be a simple one.

The economy seems to be growing steadily at a 2 per cent annual rate. Unemployment is declining slowly, though in a somewhat jerky path from month to month.

Inflation admittedly ticked up for a while in the summer, but the October retail price figures indicate that the underlying situation fully justifies last week's modest base rate cut.

This relatively relaxed situation is not atypical for the present stage of the business cycle. It replicates the early years of the 1980s, when the economy behaved rather well for a while despite constant carping from most onlookers.

This time it is clear that Kenneth Clarke inherited from Norman Lamont an unusually tame 'inflation monster' which should prove of considerable benefit to him throughout his term in No 11.

In one sense he will need to be a particularly incompetent Chancellor - which so far he shows no signs of becoming - to blow his inheritance. In other senses, however, his situation is much more difficult. In particular, it falls to him to correct a problem that has been building up in both boom and slump for more than a decade.

In short, the economy is consuming too much. Correspondingly, it is investing and exporting too little.

This is not an easy problem to correct, since its solution inevitably involves a period in which consumers receive less than the full fruits of their labours - just as they have systematically received more in the past 10 years. Nevertheless, a litmus test for the Budget will be whether the problem is fully addressed.

The consumption problem applies to both the private and public sectors. In fact, the sum total of public and private consumption now absorbs about 87 per cent of everything we produce in the economy compared with about 83 per cent a decade ago.

This rise of 4 percentage points in the consumption share may not sound very much, but it is something of an economic earthquake which more than accounts for the deterioration in the trade balance over the same period.

Furthermore, part of the problem almost certainly stems directly from the overgenerous budgets of the 1980s, which reduced the burden of personal taxation by about pounds 20bn a year, or 3 per cent of national income. Nor were the lost oil revenues ever fully replaced.

These tax changes, together with the impact of easy monetary policy on asset prices and consumer confidence, comfortably explain the build-up in consumption during the boom.

More surprisingly, the buoyancy of consumption has not been corrected during the recession, which has instead seen a collapse in investment and an unusually modest improvement in the trade balance. Mr Lamont's last Budget in March addressed the problem by adding pounds 10.5bn to taxes, mostly on the consumer, by 1995-96. This bought some time, but it may well prove to be insufficient.

So how much more needs to be done? One way of answering this question - though it produces only a partial answer - is to examine the issue solely from the perspective of the government accounts.

The budget deficit this year will be about pounds 50bn, or about 8 per cent of national income, which is clearly an unsustainable figure from any perspective. But part of this deficit will undoubtedly melt away as the economy recovers, so many economists argue for a 'wait and see' approach to further budget tightening.

Although the economy is now growing rapidly enough to reduce unemployment, the level of output remains below its long-term trend, which obviously explains part of the budget deficit. By the time the economy next attains normal capacity working the budget deficit must be reduced to a satisfactory level.

What does this mean? There can be two definitions - the deficit might be reduced sufficiently to ensure that the ratio of outstanding Government debt to national income is stabilised, or alternatively to ensure that Government debt grows in line with public assets, thus leaving the net worth of the public sector unchanged.

(The latter formulation is the so-called 'Golden Rule' of public finance, about which we may hear more from the Chancellor tomorrow.)

By coincidence, given the present level of public investment, both these approaches suggest that the budget deficit (PSBR) should be reduced to about 2.5 per cent of GDP by 1997-98, by which time the economy would have returned to normal capacity working, assuming it grows by 3 per cent a year in the meantime.

On Goldman Sachs-Institute for Fiscal Studies forecasts, illustrated in the graph, the PSBR will fall to around 3.5 per cent of GDP by 1997- 98, so the Chancellor needs to increase taxes by a further 1 per cent of GDP to ensure that debt sustainability and the 'Golden Rule' are achieved.

This is not a large amount, especially considering the huge uncertainties involved in any medium-term projection of the PSBR. Consequently, on narrow grounds of public finance, the case for further tax increases seems debatable. However, there are wider considerations.

It is all very well to 'assume' that the economy will grow by 3 per cent per annum to return to normal capacity working by the end of the Parliament, and then to assess the implications of this assumption for the PSBR.

But this simply sidesteps the crucial question, which is whether the economy can grow by 3 per cent per annum in the first place without triggering unacceptable problems with either inflation or the balance of payments. To answer this question we need to specify a medium-term path for the entire economy, not just for the public accounts.

This is where difficulties arise. If domestic demand grows at 3 per cent per annum - as well it might with interest rates close to 20-year lows - the trade deficit is likely to deteriorate over time. And, as everyone now knows, it is starting from an unusually large deficit running at around 1.5 per cent of GDP in the first half of this year.

If sterling remains close to its present levels the trade deficit could on this scenario widen to about 4 per cent of GDP by 1997 - a potentially dangerous level.

(Graph omitted)


The worsening in the trade deficit could be mitigated by allowing a further sterling devaluation over the medium term. For example, if sterling slides by 15 per cent between now and 1997, the trade deficit could be held at present levels while the economy grows at 3 per cent per annum.

But the snag is that the devaluation would result in inflation eventually rising quite sharply to 5.5 per cent by the end of 1997 - and the trend would still be clearly upwards.

In fact, however we rearrange these particular deck- chairs on the Titanic, it may prove impossible to achieve a satisfactory outcome for inflation, trade and the PSBR simultaneously in the next few years. But is seems more likely that this can be achieved if the budgetary stance is progressively tightened while sterling remains fairly competitive.

In a year's time election season will be approaching, the Tory majority in the Commons will be even narrower and tax increases or public spending cuts will be all the harder to implement. This could be the last chance for some years for the Chancellor to dent the twin deficit problem, and it must be taken.