'Green Budget' suggests tax or interest increase to keep inflation on target

THE CHANCELLOR should reject tax cuts in the forthcoming Budget and should also consider more tax increases or higher interest rates next year in order to keep inflation in its 1-4 per cent target range, according to economists at Goldman Sachs and the Institute for Fiscal Studies.

In their widely read annual 'Green Budget', a dry run of the policy debate under way at the Treasury and Bank of England, the economists suggest there are potential inflationary dangers despite yesterday's favourable retail price figures. One reason is that the level of spare capacity in the economy is lower than is generally thought due to scrapping of plant and equipment during the recession.

If gross domestic product continued to grow at its present rate of nearly 4 per cent a year, inflation would break out of the top of its target range by the middle of 1996 and continue to rise sharply.

A second reason for recommending tighter policy is the high level of household savings. The private sector has an almost unprecedented financial surplus, equivalent to nearly 6 per cent of GDP, thanks to high income growth and reduced borrowing.

This surplus is unlikely to last. The tax increases announced in the past two Budgets have helped reduce the risk of a surge in consumer demand. But the Green Budget recommends more tax increases in order to continue rebalancing the economy away from consumption and towards investment and exports.

Since more personal tax rises are likely to be politically impossible in the approach to the next general election, the alternative is further interest rate increases in 1995 and 1996. Base rates are predicted to reach 7 per cent by the middle of next year.

The unexpected health of the economy means the Government will be in the red by less than the Treasury had forecast in the current financial year. The Green Budget predicts a public sector borrowing requirement of just under pounds 32bn in 1994-95, compared with the Treasury's summer forecast of pounds 36bn.

Lower-than-expected inflation would allow the Chancellor to announce a reduction in spending of about pounds 5bn without making any cuts in the real provision of public services. This would reduce the PSBR to pounds 21bn in 1995-96, and reduce the need to raise taxes in subsequent years.

With an unchanged nominal spending total, implying an inflation-adjusted increase of 2 per cent, the PSBR would be pounds 24bn. On optimistic assumptions about the strength of economic growth, the public sector could return to surplus by 1997-98.

An unchanged or lower target for the PSBR would not prevent improvements in individual tax and spending programmes. The Green Budget team reckons the prospect of reform of corporation tax in order to reduce companies' dividend payments has receded.

If Kenneth Clarke did go ahead with a reduction in the rate of advance corporation tax and the corresponding rate of tax credit paid to tax-exempt investors such as pension funds, the adverse effect on share prices could be limited by cutting the rate of corporation tax. According to Sushil Wadwhani, equity stategist at Goldman Sachs, abolishing ACT and using the money to cut corporation tax from 33 to 25 per cent would trim share prices by only 2-3 per cent.

The Green Budget suggests Mr Clarke could introduce improved capital allowances for small companies. Changes to personal taxation are unlikely, with the last stage of increases announced last year due to take effect in April 1995.

The Chancellor has indicated that he would like to improve incentives for people at the bottom of the pay scale to take jobs. The Green Budget suggests he will introduce reforms of family credit and housing benefit, to reduce the rate at which the low-paid would lose benefits as their earnings rose.

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