Outlook: Chancellor's Budget arithmetic feels strain as luck runs out

Inflation targeting; Property boon
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Gordon Brown hates being described as the "lucky Chancellor", for in his eyes he's made his own luck in the prudent and steady way in which he's managed the economy. Yet he's going to need something close to a miracle to stay within his self imposed rules governing the public finances over the next few years.

Even on his own, still optimistic projections of the future, he's perilously close to breaching the golden rule that says the government can only borrow to invest over the lifetime of the economic cycle. Borrowing for this fiscal year is projected to be £10bn higher than was forecast in the Budget, which was in itself nearly double the previous estimate. The really worrying feature of this shortfall is that it is happening despite the fact that, against the odds, the Chancellor will meet his growth forecast for this year.

The numbers are failing to add up. Nobody would have given the Chancellor a snowball in Hades' chance of achieving his growth forecast six months ago, but even though the lucky Chancellor has done it again, tax revenues are falling short and spending is overshooting. There is now every reason to believe the ever widening hole in the public finances is a structural rather than a cyclical phenomenon. The Chancellor sold his ambitious public spending plans to the nation on the basis that the economy could afford them. That claim is now open to question.

Still, the Chancellor can at least point to the fact that although things are turning out worse than he expected, they remain a lot better than almost everywhere else. The Budget deficit this year will be 3.3 per cent of GDP, which is in breach of the Maastricht ceiling of 3 per cent. Yet compared with Germany, France, and the United States, the deficit looks a paradigm of virtue, while set against Japan, where the deficit this fiscal year is expected to be approaching 8 per cent of GDP, it scarcely seems worth worrying about at all.

Even so, the "prudent" Chancellor seems to be throwing caution to the winds in relying on a strong cyclical upturn in taxes to come to his rescue over the remainder of this parliament. The evidence already suggests that it won't, even assuming the economy remains at close to full employment. On the Chancellor's own projections, growth in consumption is destined to abate, which means a slowing of growth in VAT receipts. Corporate profits are recovering, but probably not by enough to compensate.

The miscalculation the Chancellor has made is in assuming the buoyant tax revenues enjoyed at the top of the boom had established a new benchmark that would be sustained as soon as the economy returned to decent levels of growth. In fact it looks as if they were a bubble-inspired one off. Even with a resumption of growth, the nation has gone back to a more normalised tax base at a rather lower level.

Despite these strictures, it is none the less hard to see what else the Chancellor might have done. You can argue all you like about whether the Chancellor's extra spending commitments are a sensible use of money, but to tighten fiscally at this stage of the cycle in order to correct a perceived problem in the public finances would be utter folly economically, as well as politically suicidal. Nobody else in the world is doing it, and for Britain to be alone in pursuing such a policy would be taking prudence to ridiculous extremes. The Chancellor is in any case only doing the same as householders up and down the land ­ spending beyond his means and using the debt markets to finance it.

In any case, the debate should focus not so much on the size of the deficit, or the somewhat arcane argument over whether the Chancellor is breaching his own rules, but on whether we are getting value for money from all that extra taxes and borrowing. The tax take as a proportion of GDP is creeping relentlessly back towards the 40 per cent mark, from the low point of less than 33 per cent it reached at the tail end of the Major government. That's too high to sustain the enterprise culture the Chancellor aspires to.

The Chancellor said in yesterday's pre-Budget Report that he would be removing 147 regulations in his own bonfire of red tape. But at the same time he's emptying a lorry load of extra, unproductive work on companies by reforming the transfer pricing and thin capitalisation rules, a measure that appears to be of no benefit to anyone other than as a job creation scheme for box tickers. No wonder that business leaders are exasperated by their "pro-business" Chancellor. He speaks the language of enterprise but works with the dead hand of a practised bureaucrat.

Inflation targeting

The Bank of England says the new inflation target has only limited implications for monetary policy. This is because what the Monetary Policy Committee does in setting interest rates is target inflation two years out. By then, the new measure of inflation, the Consumer Prices Index, is forecast to have converged with the old one, RPIX, taking into account the arithmetic difference between the two indices of 0.5 per centage points.

Ergo, monetary policy doesn't need to be any tighter or easier than it is now to ensure that the new target of 2 per cent under the Consumer Prices Index is met two years out. The main reason for the convergence in expected rates of inflation is that the Bank of England thinks house price inflation will abate to zero during the two-year time frame. One of the big differences between the Consumer Prices Index and RPIX is that the new index contains no measure of house price inflation. If house price inflation is eliminated, then the difference becomes academic. That's the theory, anyway. So what happens if house price inflation doesn't abate? It still makes no difference, says the Bank of England, because the MPC will factor in the effect of house prices on demand and consumption in its rate decisions even if they don't explicitly show up in the Consumer Prices Index.

Well, maybe, but there is still plenty of scope for confusion in a process that is already opaque enough. RPIX will continue to be used for the purpose of indexing benefit and tax thresholds. Most unions will also continue to use it for wage bargaining purposes, if only because it is higher. There is plainly some merit to the Bank in using an internationally recognised and, arguably, better constructed measure of inflation, but to use one that doesn't properly reflect most people's cost of living in Britain seems perverse.

For instance, besides housing, the new index also doesn't include household insurance, council taxes or school fees. Yet bizarrely it does include foreign students' university tuition fees. It is hard to argue that the new inflation target represents an advance in the quest for greater transparency in monetary policy.

Property boon

Budgetary statements are generally more notable to the myriad of different interest groups that perennially lobby the Chancellor for what they leave out than for what they contain. On this occasion, one of those groups, the property industry, has scored a couple of rare successes.

First, it has persuaded the Chancellor to consult on the creation of Real Estate Investment Trusts (REITs), a form of property ownership, which has been the salvation of the quoted property sector in America, Australia and France by removing the double taxation through corporation tax of rental revenues.

The other breakthrough was in persuading the Chancellor to allow pension funds to invest in residential property, which ought to lead to a marked improvement in residential construction. Two hits in one statement and no increase in stamp duty to boot. For the property world, if no one else, it's Christmas come early.