Robert Chote: Our deficit has got nothing on America's

The Treasury forecast in March that the current budget deficit would halve in 2004-05. But so far it hasn't shrunk at all
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The Independent Online

They'd been over-optimistic about the public finances for three Budgets running, but Treasury officials were quietly confident in March that this time they would be right. With half the current financial year now elapsed, however, Gordon Brown is still waiting anxiously for his luck to turn.

With the general election just a few months away, this is clearly embarrassing for the Government. On current trends, Mr Brown is now on course to break the self-imposed "golden rule" that is supposed to help constrain how much he borrows. And it looks increasingly likely he will have to announce fresh tax increases before too long to claim plausibly that he can be confident of meeting the rule in the future.

The Treasury predicted in March that the current budget deficit - tax revenues minus non-investment spending - would halve in 2004-05 from the £22bn recorded last year. But in the first half of this financial year the deficit has not shrunk at all. Meanwhile, independent forecasters expect economic growth in 2004 to be in line with Mr Brown's Budget forecast at 3 to 3.5 percent. So a temporarily depressed economy cannot be held to blame.

If this trend continues, the £11bn overshoot in borrowing this year would be a little under 1 per cent of national income. By historic standards, this is not a particularly large gap, even over this relatively short time. The problem for the Chancellor is that his forecasts in recent years have persistently erred in the same unfavourable direction. So having predicted two or three years ago that the golden rule would be met with plenty of margin for error, his room for manoeuvre has gradually been exhausted.

The golden rule requires the Chancellor to keep the current budget in balance or surplus on average over the ups and downs of an economic cycle. This is supposed to ensure broadly that future taxpayers only have to repay debt which has financed spending from which they benefit. It is an imperfect way to achieve this, but reasonable as a rule of thumb.

The Treasury is currently focusing on whether the rule will be met over the seven financial years running from 1999-2000 to 2005-06, which it regards as the present economic cycle. In the Budget, the Treasury predicted there would be a cumulative current budget surplus of 0.7 per cent of one year's national income over the period: around £8bn.

On current trends this would be more than wiped out by the overshoot in borrowing this year. It would be a closer call if the Chancellor managed not to spend any of the £3bn reserve set aside in his Budget forecast for unexpected spending needs this year and next. But, even if he can squirrel this away, the golden rule would be missed if any of the overshoot in borrowing relative to this year's forecast persisted into 2005-06.

So what could come to the Chancellor's rescue? First, the public finance numbers could turn around over the next six months, as officials hope.

More than half the overshoot so far this year reflects the fact that central government spending on public services is 6.6 per cent up on last year, compared to the 4.4 per cent implied by the Budget. The Treasury could try to tighten the screws, but several departments have allocations unspent from previous years that they are formally entitled to carry forward.

Meanwhile, central government revenues are up only 6.8 per cent on last year, rather than the 7.8 per cent implied by the Budget forecasts. In addition to the usual uncertainty about the distribution of revenues through the year, the outlook over the next few months will depend on the strength and composition of economic growth and on oil and share prices.

The Chancellor must also decide in next month's Pre-Budget report whether to delay further, or even for ever, this year's postponed rise in fuel duty, increasing the revenue forgone in the second half of the financial year to around £300m.

If the numbers do not pick up, the Chancellor could also improve his chances of meeting the golden rule in the short term by arguing in the Pre-Budget report that spare capacity in the economy is being used up more quickly than he thought at Budget time and that we are therefore already in the last year of the cycle. By excluding the £5bn deficit forecast for 2005-06, the golden rule would narrowly be met.

This would doubtless be greeted with cries of "fix", but it is in line with the views of independent experts. Mervyn King, Governor of the Bank of England, said recently that he saw "little if any spare capacity" in the economy. Similarly, a Goldman Sachs team calculates that the remaining slack in the economy has been eliminated since the summer - a full year and a half before the Budget forecast implied.

So curtailing the cycle looks far from indefensible. But while it might spare the Chancellor the embarrassment of breaking his rule at the first attempt, it would also mean starting the next cycle in a weaker position. This would strengthen the case for spending cuts or (more likely) tax increases soon after the election - a case that is already strong given the probability that revenues (notably from corporation tax) will not be as buoyant in the medium term as the Treasury hopes.

The silver lining to Mr Brown's cloud is that the opposition will find his difficulties hard to exploit. If the Conservatives argue that the public finances are in worse shape than they thought, it will reduce their scope to pay for lower taxes from the £23bn spending cut that they have promised for their first term in office.

Whichever party wins the election, the subsequent Budget is unlikely to be much of a crowd-pleaser.

Robert Chote is director of the Institute for Fiscal Studies.

Hamish McRae is away.

The recent deterioration in Britain's public finances pales in comparison to that which President Bush has presided over in the US. He has promised measures to halve the budget deficit over five years, but do not hold your breath.

The US budget has swung from surplus to deficit by around 7 per cent of national income since the fiscal year 2000. At most, half this deterioration can be explained by economic factors such as the loss of revenue from capital gains with the bursting of the stock market bubble. Eight years of fiscal consolidation under Bill Clinton have thus been reversed in four.

The move into surplus during the 1990s required rises in the top rates of income tax, a sharp decline in defence spending, containment of other discretionary spending, favourable demographic trends, strong economic growth and a decline in debt interest payments. Few of these influences are likely to be in place over the next few years.

On the revenue side, Mr Bush is expected to push for the tax cuts announced in 2001 and 2003 to be made permanent - a task simplified by Republican gains in the Senate. He will also face pressure to reform the Alternative Minimum Tax. This was designed to limit the ability of the well-off to benefit from tax breaks, but is set to affect a growing number of middle-class families.

On the spending side, it is hard to imagine that defence and homeland security will yield significant savings any time soon. The retirement of the baby boomers and rising interest rates will also push up social security and debt-servicing costs.

The White House claims it can reduce discretionary spending outside defence by 2 per cent a year in real terms. But that flies in the face of recent experience. According to budget watchers, members of Congress have become increasingly successful in adding spending for their constituencies to the original budget proposals put forward by the administration. And Mr Bush has conspicuously declined to veto any spending legislation.

President Clinton was persuaded in 1993 that deficit reduction would help bring down interest rates and promote economic growth. But many on the right in the US see deficits as a necessary evil to restrain government spending. Perhaps, but while we have certainly seen greater deficits in the past few years, we have yet to see them lead to greater restraint.