Hamish McRae: The figures are fine but still we're fed up. Expect more growth and gloom this year

We have no fiscal ammunition left in the locker to counter any slowdown
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The Independent Online

A new year and, as far as the British economy is concerned, what appears a brisk take-off. The pre- and post-Christmas shopping festivities seem to have been upbeat. The housing market still seems strong. UK services output is booming. And the financial markets, whose job it is too look ahead, have been generally optimistic.

That is a more cheering situation than most people expected a year ago. So is another year of decent growth, some increase in living standards and no serious upsets duly in store?

The short answer to that is, yes probably, but quite serious risks might overturn an otherwise rosy outlook. Those risks are mainly associated with weaknesses that can be identified already, though they are, I think, more likely to become really worrying in 2008 and beyond, rather than this year.

First, though, a conundrum: while the figures show 2006 was another year of decent growth, it didn't feel like it. The explanation for that is straightforward. Yes, the economy grew, but many of the benefits were absorbed in higher energy prices and higher taxation. Also, the workforce increased by, in round numbers, half a million - partly from inward migration and partly from older people returning to work. As a result, living standards did not rise as fast as the economy and unemployment crept up. Inflation hit its highest level since 1996.

For people in a handful of specialised occupations, such as financial services, much of the medical profession and the entertainment industries, it was indeed a good year. But for others, including people working in the manufacturing industry, it was tough. Expect this divergence to continue through the coming year.

Still, the broad picture does remain quite comforting. The global economy seems set to continue expanding at more than 5 per cent. Within the developed world, growth will shift away from the US and towards Europe, for while America may end up growing faster than the eurozone, the gap won't be as pronounced as in the past five years. Germany, at last, is showing some sustained growth and that is good news for the UK as well as the eurozone. Meanwhile, outside the developed world, China, India and Russia will all grow at between 6 and 10 per cent.

If the global economy has a decent year, so too will an open national economy such as our own; more than half the profits of the FTSE 100 companies come from abroad. The UK corporate sector, like that of the US, has been very profitable in recent years - more so, in terms of profits as a percentage of GDP, than at any stage for the past 40 years. Insofar as more profitable companies mean higher investment and more jobs, this is all encouraging stuff.

There are, as always, risks. One has become obvious in the past couple of months: inflation well above the target of 2 per cent on the new consumer price index and close to 4 per cent on the old retail price one. Do not expect a rise in interest rates this week after the next meeting of the Bank of England's Monetary Policy Committee, but do expect one in February.

The financial markets think that will be the last one this cycle, but I'm not so sure. If the housing market steams on this year and that continues to fuel both consumption and, less directly, inflation, then the Bank will be forced to act.

Mortgage approvals are at their highest level since 2003, at 129,000 in November, which suggests that the housing market will be well-supported through this year. It will also help support retail sales - the economics team at Citigroup has plotted the relationship between the two in the left-hand graph.

I still think rates have a chance of reaching 6 per cent at some point in this economic cycle, though even to advance this as a possibility is a minority view.

A second and rather different risk is that the UK fiscal position will deteriorate even further in the coming year and that action will have to be taken to tackle this. We will presumably have a new Chancellor in the summer, with Alistair Darling the most credible candidate. Mr Darling would be a safe pair of hands and has a sensitivity to the way senior business executives think that the present Chancellor lacks. But he would inherit a fiscal position that has deteriorated structurally during the past five years.

We are stuck with a deficit at around 3 per cent of GDP despite the economy growing at or above its long-term trend. This is the result of increasing public spending as a proportion of GDP. So we have no fiscal ammunition left in the locker to counter a slowdown, as there was in 2001 onwards. We went into the last downturn with a surplus; we will go into the next one with a deficit and a deficit close to the top of the acceptable range.

This may not appear a problem this year: it could be rolled forward once again. But the next Chancellor will have to do what Gordon Brown has failed to do and put public finances on to a more sustainable footing. They are not going to put up taxes, over and above what has already been announced, in the coming Budget. A long-term public spending review is coming up and that will be a tough medium- term set of choices. But my guess is that the practical rebuilding of national finances will start with the pre-Budget report at the back end of this year.

If that is right, by the end of this year we will be feeling rather more gloomy than we do now. The aggregate figures for the economy will be fine, but most of us will be feeling the squeeze in living standards. Some of us might feel pretty fed up.

Against this sort of background, what will happen to financial markets? You have to go back to that point about the FTSE 100 groups earning their money abroad - they will be affected by what happens in the world, not particularly what happens in Britain.

But smaller and mid-sized firms are more dependent on the UK market. In the past four years, the share prices of these companies have done much better than those of the largest ones. Mike Lenhoff at investment manager Brewin Dolphin argues that when the good times roll, medium-sized firms tend to benefit relative to the largest ones. He contends that unless some shocks strike this year, they should continue to do so.

This leads to the final consideration: what are the potential shocks that might upset this relatively upbeat assessment?

Shocks, by definition, are unpredictable but you can make the general point that the financial markets, and indeed the Government, are operating on the basis that there will not be any big shocks this year - at least ones that would be sufficiently serious to disrupt the world economy. That may turn out to be right. We may be in luck. But we should not allow ourselves to run on the assumption that nothing will ever go wrong, either in our personal lives or our assessment of the national and international economy.

Corporate tax will keep falling if companies vote with their HQs

In the space of two days last week, the news came through that US food giant Kraft would move its European headquarters from the UK and Austria to Switzerland, and that President Jacques Chirac had pledged to cut French corporation tax to 20 per cent.

The reason for the Kraft move? Apparently it is partly better infrastructure but also a lower corporate tax. It is not alone among the US giants. General Motors, Hewlett-Packard, Procter & Gamble and Pfizer also have their European head offices in Switzerland, though they have operating companies all over the Continent. Corporate tax rates vary from canton to canton (Zug has a zero rate) but Switzerland as a whole is more friendly that most of the old EU member states.

As for the French tax position, you have to take the statement with a pinch of salt. The President has made tax pledges before that have come to nought, and this one - a reduction from the present 33 per cent to 20 per cent - is over five years. So Mr Chirac can make the pledge without having to face the consequences, for the proposal covers a period when he will no longer be in office.

Still, it is pretty clear that European corporate tax rates will continue to fall. The process has been given a prod by EU enlargement, for the accession countries had lower taxes than the existing members. At a stroke, the unadjusted average tax rate fell by about five percentage points. The UK 10 years ago had one of the lowest tax rates in the EU; now it is above average. And every time a company moves its headquarters, you lose not only the corporate tax revenue but also the associated revenue from employees who move with it.

The question is how low will corporate tax rates go. Intuitively, I would have thought they will level out between 15 per cent and 20 per cent, but the really radical solution is to junk them altogether and find other ways of raising revenues. That will only happen if companies actually do move, though, rather than just talk about it. That is why the Kraft move matters; another problem looms for Gordon Brown's successor.

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