Bill Robinson: Spending or taxes - whatever the Chancellor hopes for, something will soon have to give

From a fiscal point of view, it was rather dull. A small amount of money was raised by closing tax loopholes and used to finance a cash handout to the elderly. All the commentators said it was very political. I am talking, of course, about last year's Budget.

From a fiscal point of view, it was rather dull. A small amount of money was raised by closing tax loopholes and used to finance a cash handout to the elderly. All the commentators said it was very political. I am talking, of course, about last year's Budget.

The truth is that the Chancellor had no fiscal room for manoeuvre last year, and he has none this. So we have had two very similar Budgets. Last year there was a net giveaway of £725m. This year there is a net increase in tax of £265m. These are tiny sums (less than 0.1 per cent of GDP), so both Budgets were, in effect, neutral. The Chancellor is, to his credit, attempting to follow his self-imposed fiscal rules and campaigning mainly on the strong economic performance that has been delivered on his watch.

Growth is currently above trend, but how much longer will that continue? In 2004, the Chancellor predicted growth of 3 to 3.5 per cent. This forecast was seen as somewhat optimistic by outside commentators, who at the time were on average predicting growth of around 2.8 per cent. But the out-turn of 3.1 per cent vindicated the Chancellor.

This year the pattern is repeated, with the Chancellor forecasting growth of 3 to 3.5 per cent, compared with an average of independent forecasters of 2.6 per cent.

He may again confound his critics. But three key economic indicators, which were pointing clearly upwards a year ago, have now turned the other way. The Purchasing Managers Index is perhaps the best short-term barometer of business activity and, though not yet signalling a downturn, it is distinctly less bullish than a year ago. Retail sales growth has slowed sharply in recent months, following a disappointing Christmas on the high street. And UK house price inflation is also falling rapidly. That deceleration is, so far, well short of the collapse that many feared, but the risk of the downward trend continuing could explain the increasing caution of consumers.

In 2003, the construction industry was a star performer. Helped by the housing boom, it delivered average growth of over 5 per cent. But by the year to the fourth quarter of 2004, construction growth had slowed to only 2.4 per cent. So although the business services sector continues to perform strongly, there are good reasons to believe, with independent forecasters, that this year may not be quite as good as last.

Life remains particularly difficult for manufacturing - which again posted the weakest growth of the main industry sectors in 2004. Although the UK has significantly outperformed the euroland economies in recent years, this is not true of our heavy industry. The chart shows that the UK manufacturing recession in 2000-02 was as big as that of the early 1990s, and has been followed by nearly three years of zero growth. In continental Europe, by contrast, the recession was shallower and some recovery is now evident.

The prospects for the sector do not look bright. The Treasury is forecasting growth of 1.5 to 2 per cent - well below its GDP growth forecast - but even that may be hard to achieve. The manufacturing recession of the early 1990s was brought to an end in large part by the UK's exit from the European exchange rate mechanism, which gave our exporters a competitive edge (over two-thirds of manufacturing production is exported) and launched a period of steady growth.

Nothing similar is in sight today. Manufacturers are struggling with low-cost competition from the Far East, and especially from China whose currency is locked to a falling dollar. The large multinationals are responding to this threat by relocating production to the accession countries (the new members of the EU), where labour costs are a fraction (typically around a fifth) of "Old Europe" levels. So don't expect a manufacturing boom in Britain - or indeed in euroland, which has to contend with the strengthening single currency.

On the fiscal front, the best news is that the economic recovery has finally halted the deterioration in Britain's public finances. However, the 2004-05 current budget deficit (excluding net investment), which is what matters for the Chancellor's "golden rule", is at £16.1bn still well above the £10.5bn forecast in last year's Budget. This is better than last year, but worse than expected. Only a significant undershoot in net public investment, which the Chancellor wants to boost, allowed his overall borrowing numbers to come in close to target.

Furthermore, the extent of the improvement in coming years is in doubt. The Treasury believes that relatively fast growth will continue to boost tax receipts and deliver further reductions in public borrowing, despite the rapid planned public spending growth in 2005-06. The Chancellor therefore expects that his golden rule of borrowing only to invest - will be met by a wafer-thin £6bn margin (less than 0.1 per cent of GDP) in the current economic cycle ending next March. He then predicts that the current budget balance will return to modest surplus over the next few years as spending growth slows down, enabling his fiscal rules to continue to be met in the next cycle.

Other professional economy watchers - including the Institute for Fiscal Studies, the OECD and the IMF - take a less sanguine view. If they are right (and our own modelling - see the chart above - suggests they may be) then hard choices will be necessary to preserve the health of the public finances in the next economic cycle. The first key decision point is likely to be the 2006 Budget, when the Government (if re-elected) is due to announce its new total spending plans for the three years to 2009-10. Unless it takes a much tougher line on public spending in that review, taxes are likely to need to rise.

Bill Robinson is director of economics at PricewaterhouseCoopers.

Take three: Brown's box-office tax flop

Mike Leigh's Vera Drake may not have garnered an Oscar for its deserving star, Imelda Staunton. But it was the sort of well-made, well-received film that Gordon Brown says he hopes to encourage with his tax breaks for the British film industry. But all the Chancellor is doing is sowing the seeds of confusion. If anything, the changes he announced on Wednesday will lead to fewer films being made, not more.

The taxation of films is never simple - and given that changes in the regime were announced in 2003, 2004 and this year, that is not going to improve. The old regime allowed film producers to claim tax relief on what they spent on films - in the year they spent it. But as most producers didn't have any profits on which to pay tax, and so couldn't take up the benefit, the system was open to widespread abuse, with producers "selling" their tax breaks to partnerships such as law and accounting firms.

To sort this out, the Chancellor said last year that he would bring in a new set of tax credits for low-budget films (under £15m). These were launched at a party in London's West End and hailed as the saviour of British films. This year, he announced he was extending this tax credit system to all UK films.

There is just one problem: the regime hasn't started yet. Jonathan Ivinson, a film tax expert at lawyers Hogan & Hartson, said there was massive uncertainty in the industry and that this could cause the financing of some pictures to fall through. "This is a failure by the Treasury, and I'm sure it's not what the Chancellor intended."

What's more, the changes will mean that only the producer will get tax relief for the picture; there will not be any tax breaks for investors in British films. In Germany, for instance, any investor in any film can get tax relief (leading to the curious situation of Germans putting their money into Hollywood blockbusters).

These days the film industry is extremely mobile. Films you think are British are often made in Ireland, the Czech Republic or Hungary. The UK industry has suffered in the past because of the heavy-handed taxation of Hollywood stars when they come to film at British studios. And it will continue to suffer if the Treasury can't get its act together on tax treatment.

Mr Brown tried to present his changes as a "Vera Drake". But it ended up more like the Sex Lives of the Potato Men.

Jason Nissé