Hamish McRae: Brown can't afford one slip

Can the Chancellor sustain his planned sharp rise in public spending in the face of uncertain growth? Or will the next set of spending plans, out later this month, become an exercise in hope rather than delivery?

Can the Chancellor sustain his planned sharp rise in public spending in the face of uncertain growth? Or will the next set of spending plans, out later this month, become an exercise in hope rather than delivery?

This is hugely important. If the economic proposition to voters in Labour's first term was "we can deliver competence", in the second it has become "we can deliver better public services". But the first term was helped by a global economic tailwind, the second is already butting into a headwind. While Britain has come through the last 12 months in better shape than other large developed countries, it needs to carry on growing reasonably swiftly to pay for the Chancellor's plans. Maybe it will, but the recent market disarray raises obvious doubts.

First the good news: the UK came through last winter without a single quarter of negative growth. In fact, the latest revisions show it actually kept growing, as many of us expected. More than this, both the global cyclical indicators and the UK ones are heading sharply upwards, the UK relatively fast (see left-hand graph above).

I like these cyclical indicators because, though they don't tell you much about the strength of each cycle, they do give an early warning of trouble. Thus they showed right back in 1999 that a downswing was likely. Had more people paid attention, there might have been fewer tears in the hi-tech investor community. Now they are saying the reverse. Add in further evidence from industry – the CBI survey of business sentiment is now sharply up – and you have to be pretty negative not to acknowledge that some sort of upturn is likely to take place. The market worries, I think, are more precise: they focus on the still-high value of shares relative to profits and the possibilities of further accounting scandals rather than the durability of the recovery. Of course, the falls in share prices could themselves undermine economic confidence and at worst they might lead to a double-dip. But there is not much evidence yet of any serious threat to the recovery.

However, the recovery remaining intact is a necessary but insufficient condition for financing public spending plans. It has to be strong, pumping out reliable growth at about 2.75 per cent year in, year out through the next five years. A couple of slow years and there would be trouble.

Public spending as a percentage of GDP is a long way down from its peak in 1976, and taxation from its peak in 1981 (both shown in the middle graph). But the pres- ent plans bring spending back to the level of 1995 and, more particularly, tax to that of 1989. In a year or so, taxation will be the highest for about 15 years. And that is on favourable assumptions of growth.

If growth falters, what happens? Several EU countries have been bumping up towards the 3 per cent of GDP ceiling they are supposed to remain under as a result of slow growth in Europe. In the US the government has swung from surplus to deficit, largely because of lower-than-expected tax receipts. (The deficit will rise further because of higher spending and an ill-designed tax cut.)

The Chancellor would argue that UK finances are about the soundest of all the large developed countries, with a relatively low tax burden even after present increases and a relatively low debt burden. He would also argue, rightly, that public spending plans should be viewed across the economic cycle. It is absurd to cut spending at a time of slowdown because that would add to the downward pressures. He would argue too that the framework is strong enough to carry the spending plans through the downward leg of a cycle. That is why he used the last four years to strengthen public finances, pay back debt and so on.

Well, maybe. The problem is that the fiscal position can flip round horribly fast. Look at the way the gap opened up to 8 per cent of GDP in 1991: receipts down to 36 per cent of GDP, spending up to 42 per cent.

Look, too, at the scale of the planned increases (right-hand graph). During the fat years of the late 1990s, public spending either fell in real turns or at least rose only slowly. Look what is planned from now on: spending going up at 4-5 per cent a year, far greater than any possible rise in GDP. The peak increase is projected at 6 per cent of GDP. And this is taking place in what are likely to be leaner years for growth.

So what will happen? On favourable assumptions of growth – say an average of 2.75 per cent a year, plus no severe external shock, plus no severe internal shock (like a collapse in house prices) – I could see the Government getting by. Financing these projected spending rises could just be done without any further big rises in tax. But you have to make favourable assump- tions. Every variable – the world economy, UK employment and so on – has to turn out towards the favourable end of the scale. The Treasury would say it has made middling assumptions. I think most outside forecasters find that hard to accept.

If things turn out less favourably, there will be three options, all unpalatable. One is to raise taxes. The problem there is that the Chancellor has done about all that is acceptable in the way of stealth taxation. So more rises would be real and damaging.

The second is to borrow more. There is lots of leeway there, but to be credible, a rise in borrowing would have to be accompanied by rises in taxation and/or cuts in spending. Otherwise the Government would find its borrowing costs rising.

And the third is to cut those spending plans. Actually, I doubt that additional money on this scale can be wisely spent. Already there are signs that the extra cash spent on the health service has been associated with a decline in productivity, not an increase.

We will see. Meanwhile, note the twin threats: we can't afford the spending plans on present tax levels; and we don't get value for money from them. The problems are clear, even if the outcome is uncertain.