Hamish McRae: The Chancellor doesn't do humility but something will have to give on spending

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"Give me lucky generals", said Napoleon... and as I have noted before, Gordon Brown has been an astoundingly lucky Chancellor. It looks as though he may now be lucky again.

At the beginning of next month he has to present his pre-Budget report, outlining changes to public spending plans and giving some indication of tax measures in the forthcoming Budget in the spring.

He will have to gloss over the obvious embarrassment of getting his forecast for the economy wrong. Back in the last Budget he was forecasting 3 to 3.5 per cent growth, a level that many of us at the time felt was a pre-election puff. Now it looks as if it will be around 1.8 per cent, a bit lower than even the pessimists among the independent forecasters thought then.

Slower growth should mean a worse budget outcome, for tax revenues are likely to be lower and spending on benefits higher. For most of this year tax receipts have indeed been running below forecast and spending above it, with the result that the projected deficit, far from being lower than it was last year, looked like being higher. The estimated size of the resulting "black hole" was £10bn, suggesting that either taxes would have to go up by that amount, or spending trimmed.

Growth continues to be much worse than expected, and until recently public finances have also been pretty glum. But now, suddenly, hey presto, revenues have perked up and spending has gone down. In October, instead of the debt going up as expected, the Treasury was £5bn in the black. Result: the Chancellor can reasonably claim next month that he won't have to put up taxes after all.

Knowing his ability to turn bad news into good, I expect he will blame the slower-than-expected growth on the surge in energy prices and argue that despite this external shock, public finances are still on course. Miss Prudence survives again.

What has happened? Well, this is only one month's figures so let's not get too excited, but there seems to be two factors at work. One is a jump in corporation tax revenues which may be partly on the back of the higher oil price; the other, a squeeze on current spending, which is now running below the level of last year.

On the former there is not much to be said. Corporation tax receipts are lumpy but the Inland Revenue has close relations with the large companies and will know what to expect. The three-monthly returns on this tax are running 23 per cent up on the same three months of last year, which is encouraging, and there does not seem to be any reason to think this trend will deteriorate. So in as much as this reduces the need to put up personal tax rates, good news.

On the spending side, what seems to have been happening is that the various government departments went on a bit of a binge in the first half of the financial year and are now cutting back. I suspect they are being forced to cut back, with the Treasury cracking the whip. Spending is still running nearly 8 per cent up year-on-year, against a projected rise of 5.6 per cent, so expect further cutbacks in the next few months.

And the outcome for borrowing? Most City economists still expect an overshoot. For example, Barclays Capital thinks this will be at least £4bn. But as far as the pre-Budget report is concerned, the numbers look just about credible.

This does not, however, change the long-term outlook. The reality is that the budget deficit is stuck at around 3 per cent of GDP, as you can see from the left-hand graph. We are a long way from that push into surplus of the late 1990s, an even larger surplus if you include the proceeds from selling mobile phone spectrum to the likes of Vodafone. There is still some growth, true, but it is hard to see much pick-up next year. Meanwhile, tax increases already in the pipeline are squeezing down the growth of personal consumption, as Mervyn King, Governor of the Bank of England, warned last week. And while the overall indebtedness of the Government is quite low by international standards, it is still rising steadily (right-hand graph). Worse, public sector pensions represent a large unfunded burden on other taxpayers, which is not caught by these debt figures.

So, in the short term, our lucky Chancellor seems to have escaped again, but the inexorable arithmetic remains. So will there be higher taxes or cuts in planned spending? Or a bit of both?

I have no evidence but I have a feeling the game is changing. I suspect the Chancellor had been reasonably confident that he could nudge up taxation receipts to preserve spending plans. That confidence must have been undermined by the experience this year. Receipts overall will be down on projections - the only issue being whether they are significantly down or not.

He will also have become less confident about the efficiency with which public money is spent. People were warning him of falling productivity in the public sector four or five years ago and he dismissed those concerns. It is hard to measure productivity in any service industry and in public services more than most. But the numbers now are unequivocal: the output of the public sector has not been rising as fast as the input. He is not stupid, and he can see something is going wrong, and must be disturbed.

So we will see a change of mood. The outward form will be the same - how wonderfully the country is doing though we must do much more - but he knows he cannot admit to having to put up taxes in any significant extent. Nudge and squeeze but nothing wholesale. He also knows people need to feel they are getting better value from the public sector. So there will be much more emphasis on the auditing of performance, switching resources to the "front-line" services and so on. Efficiency savings will be expected to deliver more of the increases in output.

He won't be humbled by his poor forecasting of economic growth; this Chancellor does not do humility, not even the stage version of his next-door neighbour. But amid the bombast of the amounts of funding for public services, expect much more emphasis on the delivery side. And look at the hard numbers: how much of the extra funding for services is expected to come out of higher efficiency. The Treasury has been pretty frustrated at the ways in which some departments have wasted money, but while the cash was flowing there was not a lot it could do about this. Now it is sharpening its claws. I suspect that the latest decline in current spending is a sign that it knows it has to scrunch things down fast.

Can the bad times really be behind us?

The October blues are past. On Friday, the FTSE 100 closed within a whisker of 5,500 - the highest for four years. Yet retail sales are still soft, energy prices are through the roof, people are worried about those higher taxes and companies are complaining about margins. So why the cheer?

Several things have happened. One is that hopes of further interest rate cuts have been revived by the Bank of England's latest Inflation Report, out last week. The growth outlook was better - and inflation lower - than in the previous edition three months earlier. Higher growth should lead to higher profitability and most UK-based companies seem to be coming through the slowdown in reasonable shape.

Sterling coming off against the dollar (and a bit against the euro) will help corporate profitability too, for around two-thirds of the profit of FTSE 100 companies comes from overseas.

Another positive influence is the benign world outlook for inflation, with very little pass-through of higher energy prices and very little wage inflation anywhere. Global demand, on the other hand, has not deteriorated, with some shading down of prospects in the US offset by improved figures in Europe.

Finally - and this is a function of lower inflation expectations - bond markets seem likely to remain relaxed. That has the technical effect of making equities seem better value insofar as the lower the yield on bonds, the higher the relative yield on equities. So shares may not be better value in absolute terms but in relative terms they are.

The key question is whether this long and painful recovery from the worst bear market for a generation can be sustained for another year, or whether 2006 will be the year of the pause.

We are starting to get guestimates for next year. I like the one from Brewin Dolphin, which was very right not to be rattled by the October bump. It is for the FTSE 100 to reach 6,100 by the end of 2006 and for the US S&P 500 to hit 1,375. But I think that in celebrating the progress this year, we should all acknowledge that 2006 may be more difficult generally than 2005.