Expert View: The Chancellor's promises will have to be paid for

A re-elected government ought to take difficult decisions quickly
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The Independent Online

Do we need a Budget every year? Some say annual Budgets are harmful because businesses need stability in the tax system, not frequent changes. They might add that this year's Budget, with its plethora of small measures, is just the sort we could do without. But I stick with the unfashionable view that there is much to be said for an annual event. It provides an opportunity to take stock not just of the nation's finances, but of the UK economy.

A Treasury forecast is always an interesting event. In 2003 and 2004, Gordon Brown was more optimistic than the consensus on growth and was proved right (though his tax revenue forecasts were too optimistic). In 2005, he was again more optimistic on growth, but this time he was wrong. The UK economy has come through a sticky patch.

Growth in 2005 was the weakest for 13 years. Consumers lost confidence after a sharp slowdown in house price inflation. Real incomes were squeezed by a rise in inflation, driven by higher energy prices that also dented business confidence.

But last year was remarkable mainly for what didn't happen. Back in the bad old days, at the first sign of rising inflation the wage demands piled in, particularly in the manufacturing and public sectors. The wage-price spiral exacerbated any small shock, turning a problem into a crisis. That has no longer happened, for three reasons. First, the power of the trade unions, and the incidence of excessive wage demands, is vastly reduced. Second, manufacturers cannot afford to meet such demands: stiff competition from low-cost producers abroad (notably in India and China) means they cannot pass them on in higher prices. And third, both sides these days have confidence that an independent Bank of England will keep inflation under control. So wage inflation is tamed. The highest annual rate since 1993 is only 5.2 per cent.

This year, the Treasury's economic growth forecast is in line with the consensus, but the fiscal forecast is still disputed. The projected public sector deficit of £36bn in 2006-07 remains worryingly large, and for the third year in a row we have witnessed a neutral Budget with no significant tax increases or spending cuts (though there were tax rises in the pre-Budget report). The lack of action, unsurprising in last year's pre-election Budget, is more worrying this year. Re-elected governments need to take difficult decisions quickly, but this time those decisions have, in effect, been deferred until the 2007 Comprehensive Spending Review, on which much now hangs.

The gap between current spending and current revenues is officially expected to be closed by the 2007-08 financial year. Outside commentators are less sanguine, though most agree that the trend is now in the right direction. The growth of real public spending, which peaked at 5.5 per cent in 2003-04, is down to 3.7 per cent in 2005-06. It is expected to fall to around 2.5 per cent for the next two years, after which an indicative number of 1.9 per cent has been pencilled in. That number would restore the public finances to reasonable health and mean that the Treasury would be able to meet the Golden Rule (current spending to match current income over the economic cycle).

However, the delivery of an overall 1.9 per cent growth rate for real public spending will not be easy. The above-trend growth commitments to health and education, both large departments, will squeeze other departmental budgets, as will the commitment to rapid growth in the (much smaller) overseas aid budget. The Government cannot escape its obligations on debt interest - projected to rise at around 2.5 per cent because of the accumulation of new borrowing - or on social security, which will grow at a similar rate. When all these are taken into account it follows as a matter of arithmetic that the combined budgets of all the other spending departments will have to be cut in real terms. Will that happen? Difficult choices lie ahead.

Bill Robinson is director of economics, PricewaterhouseCoopers