Hamish McRae: Treasury's dreadful position means a long squeeze on living standards

Economic Life
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The Treasury is in an even bigger bind than we realised. We will get the tax stimulus on Monday with the pre-Budget report, but meanwhile the underlying gap between revenues and spending has widened still further. And this is before the downturn has really struck.

We have just had the October public sector financial numbers. The running deficit has widened still further and it is easy to see why. Spending on investment has continued to run well above last year, and current spending is also well above last year. But tax revenues, which were up a tiny bit on last year, are now flat. Indeed it is probable that tax revenues in cash terms this financial year will actually be lower than last. Taxes this year were supposed to bring in £541bn, against £517bn last year, so if the tax take turns out to be down, the Treasury will be at least £24bn short. That would already be the greatest shortfall that would ever have occurred, and things will almost certainly get much worse in the months to come.

The troubling thing as far as the revenue side is concerned is that during the early part of this year revenue was running a touch up on 2007-8, but now it is only level. So there has been a deteriorating trend through the financial year.

That is what you would expect. The economy was growing or stable until about the end of July but then it started to slither down a bit in August and September. It was really only last month that things started to come off seriously. This affects tax. As you can see from the October retail sales figures, also out yesterday, spending on non-food items came down sharply, while spending on food did rise. But there is no VAT on food, so from the Treasury's point of view that does not help. The problem is not just flat sales; it is the changing composition of sales.

VAT is perhaps the most sensitive tax in the sense that any change in sentiment shows through there first. Income tax and national insurance contributions depend on the level of employment and the pay rates but both take a while to show through. People have to have notice before they lose their jobs, and it is only really in the past couple of months that hiring has dried up and redundancies started to mount. NICs were actually up year-on-year in October, through income tax was down, but while we don't have a detailed breakdown of each part of taxes on spending, it seems they were flat overall.

You can catch a better feeling for the sensitivity of tax revenue to the state of the economy by looking at the pie chart, which shows the projections for the various taxes made by the Treasury at the time of the Budget. One of the odd things I find is the way in which people become absorbed by changes in very small taxes and don't notice what is happening to the big ones. As you can see, income tax and NICs account for nearly half the projected revenues. Add in VAT and corporation tax and it is three-quarters. Council tax matters and business rates matter too, but all the fuss about inheritance tax or air passenger duty or even wine and spirits duty is irrelevant to the total tax revenue.

Put it this way. The Government is going to be, say, £25bn short in revenue this year, compared with the number it first thought of. That is the equivalent of all alcohol and tobacco duties, plus IHT, plus stamp duty and lots more all put together. What matters to the final numbers are what happens to the big taxes, not the small ones.

Look ahead to next year. There won't be any growth in the calendar year, so the question is how far the economy will shrink. There may be a little growth by the early part of 2010, but that will come too late to do much to help tax revenue. That £575.2bn figure in the middle of the pie chart is for total revenue and includes some £30bn of non-tax revenue the Government also gets, but let's assume that it turns out to be a bit lower than last year's £550bn. That is in a year when the economy was flat. If it actually shrinks in 2009-10, as it will, you could be talking of revenues coming in closer to the £520bn of 2006-7.

If my back-of-an-envelope sums are right, without this special tax boost that we are going to be told about on Monday, we could be adding £50bn to the deficit because of a tax shortfall. Allow for the tax cuts and the overall deficit for the coming financial year, the one that starts next April and therefore the last before the general election, could be more than £100bn. That would be even larger, proportionately, than the deficit run by the Tories during the early 1990s recession.

I find myself wondering how we – and our creditors abroad – will react to that. You can say that the overall level of debt at (allowing for Northern Rock and the banking bailouts) about 50 per cent of GDP is acceptable, quite low in fact compared with other countries. But that is a slightly flattering figure, since off-balance sheet debts such as the Private Public Partnerships are excluded. More troubling still, the pension liabilities of the public sector are not included either.

What troubles me is that the need to give a tax boost to the economy, which most of us would accept is desirable, is being used to conceal a really dreadful underlying fiscal position. If people realise that, they will realise that there will be a long squeeze on their living standards for a decade or so, as this deficit in gradually corrected. The rational response is to correct their own personal balance sheets, pay off debt as fast as they can, and get to work on improving their pension, because the Government in 10 or 20 years' time won't have the funds to help them.

Golden periods don't feel like golden periods at the time. People who took out big mortgages, in effect borrowing to finance a standard of living they could not really afford, now face a harsh adjustment. By borrowing yet more, the Government can postpone its own adjustment for another year. But it cannot do it for much longer than that. We have already seen what has happened to sterling as the world as reacted to what the Government is doing.

Next week will be a real test of credibility, and I hope the Chancellor can distance himself sufficiently from the actions of his predecessor to come through it.