Hamish McRae: Fingers crossed we can edge through slowdown – but tighten belts anyway

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The Independent Online

Second-day thoughts are usually better than first day ones, and Alistair Darling's first shot at a pre-Budget report is no exception.

The macroeconomic story did become clear pretty fast: the further deterioration of the public finances and the over-optimistic assumptions on which the Treasury's projections were based. But we are used to spotting that because nearly every year the outturn on government borrowing is worse than projected. We are also used to the optimistic forecasts for the economy – though in fairness the Treasury has quite often got its forecast right when the rest of us got it wrong.

The trouble is obvious. In public finance terms, the Government's numbers only work if, after a brief slowdown this year, the economy picks up next. Even then the decline in the borrowing requirement is painfully slow. If you adjust for the economic cycle, the UK has one of the worst underlying fiscal positions in the developed world.

You have to remember that the borrowing requirement is a very sensitive number, because it is simply the difference between two very large ones, both of which tend to move in opposite directions in response to changes in economic activity. Slower growth means both lower tax receipts and higher public spending.

I suppose what worries me most is not just an immediate concern: that if there were a significant slowdown akin to what seems to be happening in the US, the £38bn of borrowing needed this year could balloon to well over £40bn. It is also a longer-term concern that the deficit could rise next year instead of starting to come back down. If that were to start to happen the only possible response would be higher taxes and these would come at exactly the wrong spot in the economic cycle.

Spending as a percentage of GDP is stuck above the 40 per cent level which, while not high by the standards of the 1970s, is high by the standards of the 1980s and 1990s. And while taxation could not realistically be held down to the levels of the early 1990s, it is stuck at a level that is now quite high by the standards of the developed world and actually quite high by European standards, too.

One effect of EU enlargement has been to cut the average size of the state as a proportion of GDP. (There is a difference between the total tax take and the so-called net tax take because tax credits are counted statistically as reducing the tax burden – if they were paid out as benefits this would not be the case.)

But to what extent has the increase in public spending boosted overall demand? If spending is increasing faster than the economy as a whole and this is financed by borrowing, then the Government is a net contributor to growth. During the past seven years in which spending has surged, it has added about half of 1 per cent a year to growth.

But that influence is now more or less over; indeed public sector employment has been falling for about 18 months. So growth in the next stage of the cycle has to come from the private sector alone and the obvious question is: can it sustain this? That is the big macroeconomic uncertainty.

The big microeconomic uncertainty is how the quite considerable tax changes will, in practice, work out; and here the second-day thoughts may be clearer than the first but they are not nearly clear enough. The fundamental point to appreciate is that tax changes have, over time, enormous impact on financial structure and economic performance. For example, the Irish boom was triggered by very low (initially zero) corporate tax rates for inward investors. The UK boom in financial services has been promoted by favourable tax treatment for non-nationals and certain types of private equity investment. Now there are a series of changes which may have enormous and unexpected consequences.

To give a flavour for this, among the string of emails that have hit my screen are ones pointing to the impact on Irish people living in the UK, second-home owners, AIM companies, and new financial market products designed to shift income into capital gains. I particularly like the idea that Irish residents in Britain will now be taxed on the same basis as other foreigners: they will only have to pay tax on Irish income if it is brought into the UK. According to tax advisers Chiltern: "It's great news for Irish people."

Picking through the great mass of new information there seems to me to be three things that may prove very important indeed and one that is less important in economic terms (though very important in political terms) than it seems.

To take that last point first, I don't think the changes in IHT will have any significant effect on the economy. To merge the husband and wife allowances will help the financially unsophisticated, and actually is a most welcome simplification. But it is not going to alter behaviour significantly, as abolition might have done. People still need to plan to contain their tax liability. On the other hand, there are at least three other changes that may have a huge impact.

The first of these is the flat rate tax on capital gains. Fascinating, isn't it, that the flat tax revolution has finally reached British shores? On paper the change will bring in more money than the old system and that may well be the case. But the pressure on people to figure out how to convert income into capital gains will be enormous and it may well be that income tax revenues suffer as a result. The most interesting possibility it raises is whether it will eventually be followed by flat taxes on income too, though that is probably a decade or more away.

The next change is the status of non-domiciled people. Here we simply don't know what the effect will be: will there be a net gain or a net loss to overall revenue? This depends on how many people decide that the £30,000 a year fee is not attractive vis-à-vis the other deals on offer elsewhere in Europe. One thing I can predict, however. Next April the rules are also being changed about counting the arrival and departure days for UK tax purposes. So expect a much larger demand for flights into London City Airport in the morning and out in the evening and a big increase in business travel on Eurostar, too.

Finally, I am intrigued by the idea that large inward investors will be able to do a deal on tax via the Advanced Agreements Unit. The idea here is to make the UK a more effective competitor in relation to other EU destinations, such as Ireland and the Netherlands. This leads towards the notion that the UK should go the whole hog and cut the corporation tax rate to 12.5 per cent like Ireland. A flat tax for corporations, too?

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