Economic View: Chancellor loses his balance

This Wednesday we will learn how far Gordon Brown's sums are from the numbers he first thought of. We know government borrowing is running way above his Budget forecast, largely because of a shortfall in taxes. What we don't know is what, if anything, he proposes to do about it.

The pre-Budget report each autumn has become almost as important as the Budget itself. Aside from the requirement to produce a new economic and financial forecast, the Chancellor uses it to preview various measures he will announce in the Budget, as well as giving new spending limits to government departments.

This will be his most difficult year yet. In his first term of office, Mr Brown was able to play Santa. Thanks to strong economic growth, falling interest rates, buoyant revenues from existing taxes, his new stealth taxes and tight control of spending, the sums always turned out better than forecast. So he could keep announcing new spending measures and still pay off debt.

Now these favourable circumstances have flipped into reverse. Growth is still reasonable, but interest rates are starting to climb, particularly long-term rates. Revenues from some of the big taxes, especially income tax, have been disappointing. We have wised up to stealth taxes. And spending has shot up to such an extent that some people within the Government believe the Treasury has lost control. As a result, the Government is borrowing much more than forecast.

Just how much more we will learn this week. During the first six months of the financial year, it borrowed over £21bn, against a target for the full year of £27bn. That does not mean the full-year outcome will be £42bn because a large wodge of tax hits us in January. But it does suggest an overshoot. That, at least, is what the markets expect: the forecast of HSBC, for example, is for borrowing of more than £34bn.

This is worrying because, on growth, the Treasury has been more or less right. Most of us thought that its Budget forecast of growth of 2 to 2.5 per cent plus was over the top. At the time, the markets expected growth of more like 1.5 per cent. But there seems to have been a sudden spurt and some of the forecasts now suggest a little over 2 per cent may be right after all.

Good growth normally creates more jobs, which in turn bring in more tax revenue. What has gone wrong?

The first graph gives part of the answer. Total employment over the past year has indeed risen by 127,000. But full-time employment has actually fallen by 77,000 (and private sector full-time employment has fallen even more). The additional jobs have come from part-timers and the self-employed. Socially, this may be desirable, for most people working part-time have chosen to do so, while self-employment is, to some extent, a measure of economic vitality. But both groups, in the early stages at least, pay less income tax than full-timers.

You can see the shortfall in the next graph. In the first term, income tax (the bars) came in well above estimates but that, people thought, was because unemployment (the line) was also better than estimates. For the past three years, however, unemployment has continued to be better than expected, whereas income tax has been worse.

Tax revenues have other problems too. Corporation tax receipts have been poor and stamp duty on shares (but not on houses) has also fallen. Capital gains tax has been down because there have been so few capital gains. On the other hand, VAT has done well, reflecting the continuing consumer boom. Were the growth of consumption to slow, as many believe it will, VAT might be in trouble too.

The potential impact is shown in the final graph, which charts budget surpluses and deficits since 1970 as a percentage of GDP. By past standards, this dip into deficit seems modest and the Treasury predicts that we will climb back to less than 2 per cent of GDP by 2006. But if the present deficit is largely structural rather than cyclical, then we may not.

The HSBC prediction is that, unless something is done about it, the deficit will go on rising to 4 per cent of GDP. By world standards, that may not be too bad: the US, Japan, France, Italy and Germany are all in worse shape. But it would bust the Chancellor's golden rule that current spending should be balanced by taxation over the economic cycle. A huge amount of fuss has been made over the rise in personal borrowing, the extent to which consumers may be over-extending themselves, what might happen were the property market to crash and so on. But given the drag from adverse demography, maybe we should be more worried about the Government overextending itself.

Ultimately, government debts have to be serviced by taxpayers - the same people who have run up their own borrowing. But we do at least have some assets against our personal borrowings - houses, loft conversions, whatever. This rise in government borrowing is not set against additional assets, and the quality of the additional services it is supposed to be delivering is suspect.

To be clear: there is no fiscal catastrophe in the short term; and it is perfectly sensible to allow some rise in the deficit during a downturn. The problem is that this has not been much of a downturn, yet the deficit is still pushing upwards. The proposition that we should pay higher taxes for better services is a perfectly reasonable one, assuming that the services can indeed be delivered. But that is not on offer. The rather less agreeable option seems to be higher taxes for the same level of services, or much higher taxes for slightly better services. The Chancellor won't admit that on Wednesday, but he must be pondering how long he can hold things together before he moves on to whatever job comes next.