Hamish McRae: Goodbye, easy money: public spending has peaked and the only way is down

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The Independent Online

Budgets, like nostalgia, aren't what they used to be. We are just 10 days from what is potentially Gordon Brown's last set piece as Chancellor, yet there seems little sense of excitement or even fear. Not much is going to change.

The basic rates of tax and VAT will not be altered. There will be no major structural change in spending. Even the economic forecast this year will be uncontroversial, for after grossly overestimating growth last year, the Chancellor will be more cautious. There will be the usual string of "initiatives" - small dollops of spending on pet projects - and some tweaks to tax, designed to crank a little more out of the system. But nothing big.

This is, in a way, welcome. It is a relief that governments no longer make judgements about the economy and then try to fiddle with it. So Budgets no longer try to generate artificial pre-election boosts to demand, or post-election ones to cool the economy. Interest rates will not change, for that power has been unloaded to the Bank of England.

Yet this Budget is important, hugely important, because it will mark an era drawing to a close - not so much Mr Brown's time in the job but the end of the period of easy money, the fat years of large increases in public spending.

As it has turned out, spending has been strongly anti-cyclical over the past few years, but that was largely unplanned. In the early years, spending was held down in response to fears of a return to Labour's 1970s fiscal disasters, and more recently it was increased because of the Chancellor's aim to boost public services. The resulting deficit has been much larger than projected, mainly as a result of shortfalls in revenues.

You can see the way the big numbers have unrolled in the left-hand graph. One of the most surprising things to many people will be that taxation as a percentage of GDP is pretty much where it was when Labour came to power. True, Treasury projections show that it will rise, but I'm not sure I believe them: in practice, it may be hard to get the money in. More about that in a moment.

Spending, as you can see, is also projected to level off. Indeed, we are pretty close to the peak now on those projections, which come from an Institute of Fiscal Studies analysis. In fact, the big slowdown may already have begun.

The right-hand graph charts what has been happening to GDP over the past year. Every month, the National Institute of Economic and Social Research makes an estimate of growth, sector by sector, so we get an early indicator of what is happening to the economy before the official three-monthly data comes out.

Three things stand out. One is the weak but bumpy performance of manufacturing, for all the growth in the economy has been elsewhere. The second is the growing strength of private sector services. And the third is the way in which public sector growth, which had been strong in the early part of the year, has recently tailed off.

The reason for that fall-off in spending growth is that the Treasury is desperate not to break its own golden rule on the deficit, for Mr Brown's credibility would be on the line. So the word has gone round the spending departments that it would not be good for their career progression if civil servants permitted any overspending. I suspect the early resignation of the head of the NHS was, in Voltaire's phrase, "pour encourager les autres".

Looking ahead, there seem to me to be two main questions. The first is whether the spending plans as set out can be sustained; the second, whether tax revenues can rise as projected.

They are interconnected, of course. If the money does not come in, the spending cannot happen because borrowing is close to the practicable limits. It is actually above the Maastricht limit of 3 per cent of GDP. So the issue of the taxing capacity of the country is a real one.

Here you head into political territory: what is the most appropriate balance between private and state spending depends on people's political view of the world. This is a pity because dispassionate observations can be made.

One is that different countries make different decisions about the appropriate levels of spending and tax: most of Scandinavia operates with a level of both that would not be acceptable elsewhere. Another is that small countries can adopt a more nimble fiscal policy than large ones - Ireland's low corporate taxation and the Baltic states' flat-tax regimes. Still another is that appropriate levels of individual taxes change over time: the high income tax rates of the 1950-75 quarter century have been abandoned everywhere.

What is less appreciated is that there has to be consent about taxes. If they are seen as unfair, people find ways round them. That is why high earners the world over are particularly sensitive to changes in tax rates. They will already have assets in several jurisdictions and will move their business arrangements around to take advantage of incentives that governments create for them.

But consent is also important among lower earners. We saw that the country has reached the limits of road fuel tax. Prices are now higher than at the time of the fuel blockades but that is accepted because everyone knows the oil price has gone up. Not accepted is a government taking advantage of people who have to drive in their daily lives.

What worries me is that people in the UK feel highly taxed when the overall tax burden has not risen much, if at all. This suggests that, far from being skilful in his management of the tax system, Mr Brown has actually been rather clumsy. Stealth tax has had a perverse effect. How?

The best explanation may lie in the growing complexity of the tax system. If people have to cope with more paperwork at every level, they spend more time on tax matters. If they are spending more time, they may also feel they are spending more money. Those who use professional advisers are spending more money - though on advice, insurance against investigation and so on, rather, maybe, than in actual taxation. And if these concerns only affect perhaps the top 10 per cent of earners, well, they are the ones who pay more than half the income tax.

The public finances have seen a last-minute surge in corporation tax this year. But while overall revenues have been all right, they have not been as strong as Mr Brown expected a year ago. The Treasury has consistently overestimated the revenues it can collect for several years now.

Maybe the efforts of the tax gatherers can raise the take further. But at best the big growth in public spending is coming to an end, and at worst it will be hard to fund the levels we have now.

Pride comes before a fall: it happened to Japan, it could do to us

Japan's long experience with deflation seems to be over. Prices are rising again, just, and the Bank of Japan has signalled it will end its policy of zero interest rates.

For those watching Japan from afar, this is all rather other-worldly. If we could borrow at zero interest, we would all go on a spending spree. Imagine what would happen to house prices then. But Japan has had 15 years of falling prices, in property as well as in the shops. Why rush out to buy a home if it is going to be cheaper next year, and the year after and the year after that? So people didn't spend.

If all that sounds just too far removed from our own experience, consider this. Japan at the end of the 1980s was enormously self-confident, even arrogant. Its business leaders thought they would sweep the world. Property prices in Tokyo were so inflated that the theoretical value of the land under the Imperial Palace was more than the whole of California. To join one of the swisher golf clubs cost a million dollars or more.

Then came a long period of relative failure. The economy stagnated, living standards fell and Japan's perception of itself declined too. The arrogance went and although the best of its companies continued to prosper, some allowed themselves to be taken over. Nissan is now run, successfully, by Renault.

Apply these lessons to the rest of the world and note how the Chinese perceive themselves now that they have passed the UK to become the world's fourth- largest economy. I don't think they face a Japanese reversal but clearly bumps lie ahead. Note, too, how the extraordinary growth run of the US is built on something of a bubble, although again, nothing like the scale of the Japanese bubble of the late 1980s.

And us? Are we just a touch too self-confident - the Chancellor boasting about the longest period of uninterrupted growth since records began, and all that? Let's celebrate the fact that Japan is doing better at last, but let's also retain just a little humility and a little caution about our own ability to fail. We have plenty of experience of that.