Hamish McRae: Growth is better than predicted but where's the feel-good factor?

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So we were wrong to be so pessimistic about growth last year. According to a new Office of National Statistics estimate, UK growth was 2.3 per cent, higher even than the 2.1 per cent estimate in the pre-Budget report in December and a good half a percentage point higher than the consensus of economists last summer.

That put growth in the middle of the Treasury's spring estimate of 2-2.5 per cent. Assuming that the new estimates are correct, the Treasury was right and the rest of us (including myself) were wrong.

This means that the economy has shown remarkably steady growth through this whole economic cycle. As you can see from the first graph (prepared before these revisions) there has not been a single quarter of negative growth through this cycle, and if Goldman Sachs is right, there is the prospect of steady growth for the next couple of years too.

But the rest of us were not wrong about the deterioration of public finances. As you may recall, in December the Chancellor had to revise upwards the government borrowing requirement by £10 billion, despite the good growth in the economy, largely because of a shortfall in expected revenues. If growth was even faster than the Chancellor expected, the shortfall in revenues is even more alarming, for it suggests that weak tax receipts are not the result of cyclical weakness but some structural deterioration in the public sector's finances.

The Treasury may or may not make its target for borrowing this year - there are still a couple of months to go as the fiscal year runs to 5 April - but people are prepared for that. The greater worry is the next fiscal year. The Chancellor expects things to get better. They may get worse. Latest estimates from the ITEM club suggest that the public borrowing requirement of £31 billion for 2004-05 may in fact turn out to be £36 billion. Receipts from income and corporation taxes in January were down significantly from last year.

This carries on the general pattern of tax revenues: the Treasury has become more and more dependent on taxes on spending, and less and less on earning. Consumption has carried on for several years at a higher rate of growth than the economy as a whole (first graph) and, despite a bit of leakage through the shadow economy and imports of booze through Dover, that has meant that VAT and customs duty revenue have been strong. But corporation tax has been falling and income tax revenues flat.

You can see from the second graph the way in which the Treasury has consistently over-estimated revenues from taxes on income and wealth. It looks like a porcupine: the flat back of the animal shows the flat revenues, while the quills show the over-optimistic estimates at various stages in the past of the amount the Treasury expects to get in. The economic team at CSFB, which produced this graph, also thinks that there may be a structural problem on the revenue side.

Add to this the other main problem of public finances, the huge inflation in the cost of public sector services, and you can see the bind the Government is in. The third graph shows how inflation in the normal items we consume has fallen over the past decade, while since 1997 government spending growth has shot upwards and is now running at nearly 9 per cent. If the figures are even half-right - and I can't believe that the public sector performance has been quite so dreadful - it will mean that the Government will find it hard to justify the higher tax rates it will need to compensate for the structural changes in its revenue-gathering.

All this was evident before that upward revision of growth - indeed the problem has been noted in earlier columns here. The key point is that the revision suggests there is an even bigger hole in public finances than we thought. Indeed, if you go back to that first graph, you can see how the economy is likely to rely less on consumption to drive it forward in the next couple of years. That makes matters worse still because of the reliance on consumption taxes to cover the shortfall in income tax.

The bottom line is that even if we get good growth in the next couple of years and even if the government holds its spending to the rise in national growth, there will still be a rising fiscal deficit. Whoever gets in at the next general election will face a big budgetary problem.

This leads to some further conclusions that stem from these revised GDP figures. The economy picked up pace in the final three months of last year and that growth seems to have carried on through this quarter too. The Bank of England has started to lean against growth by raising interest rates and looks certain to increase rates further in the next few months. That too will feed through into a squeeze on consumption.

That is what is meant to happen and indeed there needs to be some sort of re-balancing of the economy on these lines.

But you see the point. The pattern of recent months foreshadows the pattern of the next couple of years. Yes, there will be good growth overall - or at least good growth by the standards of the eurozone. The next round of revisions to private sector forecasts may bring the average for this year above 3 per cent, which would put the consensus on a par with the Treasury. (Forecasts for the eurozone for growth this year are around 1.8 per cent.) But 3 per cent growth won't feel like that because of the squeeze on consumption. And this squeeze will go on and on.

So what's to be done? Obviously the public sector has to improve its performance. The most interesting thing last week about that spat over public spending was the common ground on this issue. The Government wants to increase public spending at the same rate as the growth of the economy, whereas the Opposition wants it to grow slightly more slowly. But both agree there are huge inefficiencies that have to be tackled.

Beyond that, I think we will have to try and understand what is going wrong with tax revenues. This is not just a British problem: US revenues are falling and not only because of the Bush tax cuts; German revenues have declined and not only because of the poor performance of the economy. We need to know whether there has been an increase in the relative size of the shadow economy, which, while quite small by continental European standards, is bigger than that of the US. We need to know whether the fall in income tax is permanent and maybe related to lower inflation in general.

Until we understand more we can expect to continue in this world of decent growth (and that is something) but a pronounced lack of the feel-good factor.