Budget needs to balance slower growth and living standards

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It is less than a week now to the Budget, the biggest card the Government has to play in the run-up to the election. Gordon Brown's job is to deliver victory, as he helped to do last time. This has led to a narrow debate and a broader one.

It is less than a week now to the Budget, the biggest card the Government has to play in the run-up to the election. Gordon Brown's job is to deliver victory, as he helped to do last time. This has led to a narrow debate and a broader one.

The narrow debate is to look at public finances and see what they imply for taxation and spending in the future. In this election by contrast to 2001 the war chest is almost empty, with government borrowing equivalent to 3 per cent of GDP. The International Monetary Fund is calling for the deficit to be curbed, while the Institute for Fiscal Studies reckons that the Chancellor needs another £10bn in taxes to pay for his spending plans. The conventional wisdom therefore is that there will be some modest tweaks to taxation and spending, coupled with the prospect of tax rises next year.

There is nothing wrong with that sort of analysis, of which there has been an awful lot. We have to foot the bill for the Government's plans so it is wholly reasonable that we should concern ourselves with the tax and spending outcome. But the broader debate is in many ways more important.

This is the extent to which, as a result of the policies of both Tory and Labour governments, the long-term UK economic performance has really improved. If it has, with the potential growth rate rising from say, 2.25 per cent or 2.5 per cent a year to 2.75 per cent, then the higher growth rate not only makes the Government's Budget arithmetic more credible, but more importantly, it carries the prospect of a continuing decent rise in living standards in the future. Even a quarter of a percentage point difference, sustained over a decade, is material.

Start with the prospects for this year and next. We have just had a year of growth a little over 3 per cent. That is just within the Treasury's own forecast range (though towards the bottom of it) and materially higher than the consensus of private- sector forecasters. Looking ahead, the general perspective is one of somewhat lower growth but no serious slowdown. The first graph shows the prospect that City forecasters (in this case Lehman Brothers) expect: growth coming down to 2.5 per cent this year and 2.2 per cent in 2006.

On the face of it that looks fine. Compared with the eurozone, which is now officially forecast to grow by around 1.8 per cent this year and Germany, which will struggle to reach 1 per cent, it is quite good. But there is a twist. Private consumption - our living standards - will rise more slowly than they have in the past, and even public spending will slow down. The graph shows some projections for growth of both public and private spending.

As you can see, household consumption slows to below 1.9 per cent this year against 3.1 per cent in 2004, and goes down to 1.7 per cent in 2006. In other words the rate of increase in living standards will virtually halve over the next two years. The rate of growth in public spending will come down even faster, from 4.6 per cent last year to 2.9 per cent this year and then 2.3 per cent in 2006.

Now these are only forecasts and they may turn out to be overly pessimistic, but they give you a taste of the problem: an economy doing well, but us not feeling we are getting the benefit of it. This will seem all the more irritating, since there is evidence that the private sector has been putting on a spurt in its performance in recent months.

The next graph shows what has been happening to private sector productivity. This is pretty astounding. If the figures are right (always an important caveat) private sector productivity growth is the highest it has been for 20 years. The productivity of the whole economy (ie including the public sector) seems to be rising at about 3 per cent but the rise in the private sector is nearly 5 per cent.

Is there a UK productivity miracle? A priori you would expect something to be happening. The UK has made a huge investment in IT, which ought to be producing an increase in productivity, particularly in the service industries. In that regard we are similar to the US but not much of continental Europe, where such investment has lagged. HSBC, which has drawn attention to this phenomenon, notes that the rise in productivity is particularly marked in distribution and financial services, the two sectors that invested most in IT in the late 1990s. There has been quite a lot of evidence of a surge in productivity in the US but until recently less in the UK. Now, however, the pay-off seems to be coming through.

If there is such a surge and it is sustainable, then a number of things follow. One is that the sustainable long-term rate of growth in the economy will be higher. And if that is the case, then there may be more slack in the economy than would otherwise be the case. The final graph shows some calculations on this from Credit Suisse First Boston. If the natural rate of growth is 2.5 per cent a year, there is now little or no slack. But if it is 2.75 per cent, there is a bit to go.

This affects the Budget arithmetic: if there is no slack we ought not to be running a fiscal deficit of 3 per cent of GDP. But if there is a bit of slack, well maybe the deficit looks more acceptable.

It also affects calculations about the overvaluation or otherwise of house prices. You can justify house prices by relating them to the buyers' incomes in the future. Faster growth means higher incomes. HSBC reckons that UK homes are overvalued either way, but on the faster growth scenario the overvaluation would be 15 per cent, against 25-30 per cent if growth were only 2.5 per cent a year.

It is very hard when you are in the middle of what may turn out to be a big economic change to know how seriously to take the evidence before you. The combination of the structural reforms of the Tory governments and the macro-economic stability achieved under Labour certainly seems to have improved UK economic performance. I don't think there is any doubt about that. But our lagging productivity has remained a real concern.

Now, at least in the private sector, maybe something important is happening. If it is, then the broad background to next week's Budget is markedly more favourable than the sceptics would admit. We really are working more efficiently. Trouble is, we won't see much of that improved performance in higher living standards in the next couple of years.