Hamish McRae: Don't worry that you feel you are paying more tax when you're not. You soon will be

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The Independent Online

Your starter question: is the UK tax bill - expressed as a percentage of GDP - rising or falling?

Your starter question: is the UK tax bill - expressed as a percentage of GDP - rising or falling?

Most people would reckon that it was rising ... and they would be wrong. It depends a bit on what period you take but in 2002 and 2003 it certainly came down and it does not seem to be rising at the moment.

That is not only contrary to popular opinion but also extremely alarming. If we think taxation is going up when it isn't, how will we react when the screw is really turned?

Now it does indeed depend a bit on what period you take. The left-hand chart on this page shows what has been happening to taxes and social security contributions since 1979. There was a sharp rise in the early Thatcher years as the government sought to correct the deficits it had inherited. Then came a steady decline. That started to go into reverse under the Major government and the first years of Gordon Brown's chancellorship. But taxes did level off in 2000 and have dipped since then. But now, on the Treasury's forecasts, it is up and up, all the way through to 2008-09.

It is worth starting with this point partly because perceptions do matter and if we feel we are paying proportionately more when we are not, that is bad news for the politicians. But it is also worth stating here because of the curious contrast between the late 1990s and early 2000s. In the late 1990s revenues kept coming in above the level the Treasury expected. You may recall early Brown budgets in which the Chancellor kept on saying that not only had he achieved this, that and the other but that he was also able to spend more on other projects.

After 2000 the reverse happened. Revenues kept on coming in below target. Our Gordon did not cut his spending. Instead he borrowed more, repeatedly upping his borrowing target, though still supposedly keeping within his self-imposed "golden rule" of only borrowing for investment, not current spending, over the economic cycle.

In the past few days new evidence has emerged that this golden rule may be breached. In itself, it does not matter, for it is an artificial creation. The worrying thing is, rather, the weakness of revenues at a time when they ought to be strong, and looking further ahead, the prospect of tax increases at a time when other countries are making tax cuts.

The idea behind the golden rule is a good one in the sense that countries ought to even out their economic policies over the economic cycle. That is the madness of the Maastricht idea that countries should keep deficits below 3 per cent of GDP, for it puts the pressure on governments to tighten policy at just the wrong time - when growth is at its slowest. But the idea that policy should even out over the cycle has to operate with a reasonably accurate knowledge of where a country is within that cycle.

Most of us think the UK is close to the top of its economic cycle at the moment. We have just had the first estimates of growth for the third quarter, which suggest growth has slowed from 0.9 per cent in the previous three months to 0.4 per cent. One should not take any single quarter's figures too seriously - they always revise them, anyway, and this year growth will still be over 3 per cent. September retail sales, also just out, were pretty strong.

Have a look at the right-hand graph, showing retail sales going right back 10 years. That looks to me as though we are near the top of an economic cycle, not near the bottom. Doesn't it to you? Yet we are running a deficit of between 3 and 4 per cent of GDP. That cannot be right. I don't think there is any doubt that next year's growth will be slower than this year's. It is unsurprising, then, that Mr Brown was warned that he is about to break his own rule. The Ernst & Young Item economic team estimates that tax revenues will fall about £6bn short of the estimates at the time of the budget, and that the golden rule will likely be broken next year. Intentionally or otherwise, and I do believe it is otherwise, the Chancellor has laid a huge time bomb for his successor. (I cannot imagine the Prime Minister wanting him to stay on in his present job beyond the next election, whatever the outcome.)

What will happen? One way out would simply be to accept that taxes will have to go up by as much as the Treasury estimates they will. Politically that might be acceptable in a scenario of another long economic boom, just as it was acceptable in the late 1990s. We might again find ourselves in a situation where revenues keep exceeding estimates. It is hard to see this, as it would require a re-run of the late 1990s bull market in shares, the enthusiasm associated with the internet bubble and so on. But in theory it is possible.

Failing that, taxes will have to go up against a background of slower growth and a squeeze on living standards. The danger there is that higher taxation would pull demand out of the economy and slow growth even more. It would not be popular either, for the money would have to come from ordinary taxpayers. Putting up tax rates on the top earners might well reduce revenues instead of increasing them.

Next possibility is a radical rethink on public sector efficiency. Last week saw the new estimates from the Office of National Statistics of the efficiency of the NHS. These confirmed earlier estimates that productivity was sinking, the new figures suggesting that the loss was about 1 per cent a year. The ONS put a lot of work into trying to get meaningful figures for healthcare.

Result? The government refused to accept the numbers, saying they did not make sufficient allowance for improved quality. That is worrying because you cannot tackle public sector inefficiency until you acknowledge that there is a problem. The idea going forward is that resources will be released by greater efficiencies in administration and redirected to "frontline" forces.

The final possibility is that there will have to be cuts in planned public spending, which would also be unpopular, but might be less unpopular than tax hikes. It may be politically difficult to increase taxes when the rest of Europe is bringing them down. I don't think many Western Europeans realised how lower tax rates in new member states would put pressure on their governments to cut rates.

But all this is for next year. This year the Treasury can manage, thanks to strong growth and the high oil price (which boosts revenues), to scramble through with slightly higher borrowing than it had expected. Next year will be a different matter.

China marches past the rest of the world

News has just come through that China is growing at 9.1 per cent - the sort of figure you have pause to take on board.

This affects our lives most directly by pushing up energy prices, but less directly by pushing down the price of goods in the shops. The goods that make up the retail sales index are falling in price by more than 1 per cent a year.

The hardest thing, though, is to accept that we are still in the very early stages of the rise in economic importance of China and India, and, to a lesser extent, Brazil and Russia. A year ago the economic possibilities for those four countries were modelled by a team at Goldman Sachs. The possibility that China would overtake the US before 2050 as the world's largest economy caused a huge amount of attention. In a new paper the same team has now looked at some of the further consequences of this great shift in global economic power.

Among these are the implications for world growth, which the authors suggest will follow a pattern. At the moment, commodity markets are most affected but soon it will be consumer goods markets too. Within 20 years they suggest that there will be more cars in China than in the US, not so remarkable a notion since there are already more mobile phones in China than in the US.

Another conclusion is that the underlying demand for energy and oil will remain very strong for the next 15 years, growing by well over 2 per cent a year. Still another is the size of the new middle class in China and India. In 20 years there will be another 200 million people with incomes above $15,000 - the average level of income per head in Western Europe less than a generation ago.

Finally, these countries will also become much more important in financial markets, for the savings and investment preferences of the new middle class will start to influence global markets.

Now, of course, something may go wrong; the course of economic development is rarely a straight line. Growing at 9.1 per cent a year risks a "hard landing". But China probably passes the UK in the size of its economy this year and at the moment it is quite hard to see what will stop it.