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Green Budget urges Brown to go steady with tax increases

Gordon Brown was advised yesterday not to increase taxes by much in the forthcoming Budget, but instead to leave it to the Bank of England to prevent the economy overheating by raising interest rates.

The advice came from Gavyn Davies, the chief economist at Goldman Sachs and a Labour Party adviser, in the investment bank's traditional joint "Green Budget" with the Institute for Fiscal Studies. It runs counter to recent lobbying from business, which would prefer tax increases because of fears that higher rates will boost the pound.

The Green Budget also warned that the Government would find it hard to save money on benefits through its welfare-to-work schemes, as only pounds 7bn of the pounds 100bn social security budget is spent on the unemployed. Andrew Dilnot, director of the IFS, said serious social security reform must instead involve the three-quarters of the budget that goes on the old and long-term sick.

The IFS urged the Government against rushing into radical reform of corporate taxation without further consultation.

The Green Budget predicted that base rates will rise to at least 7.25 per cent next year from 6.25 per cent now. It combined this with a forecast of almost no net increase in taxation beyond the windfall tax, most of which will be spent on welfare-to-work schemes.

Presenting the document, Mr Davies said: "The case for a significant increase in tax is not proven." Not only would it be politically unattractive, he said, but the underlying state of the government finances was not as bad as some commentators had suggested.

One reason was that the Public Sector Borrowing Requirement had already improved more than expected as the economy picked up, mainly because of higher corporation tax revenues. Another was that pre-announced increases in excise duties and the abolition of profit related pay mean taxes will rise by nearly pounds 6bn next year even if Mr Brown does nothing.

Assuming the Government sticks to the tough spending plans set out in last November's Budget as it has pledged, the government's finances will be in surplus by 1999/2000, Mr Davies said. This would put the Chancellor on course to meet his target of borrowing no more than the government spent on investment over the course of the business cycle, the so-called "golden rule" for taxes and spending.

He said action was nevertheless needed to prevent the boom from getting dangerously out of hand. But higher interest rates would be more effective, with a one point increase doing the job of a tax increase of pounds 8bn.

The IFS said how the Government acted on company taxation would provide a clear test of its commitment to business investment, recommending further consultation. Although a reduction in the tax credit pension funds receive against advance corporation tax would probably not have serious effects, any money raised ought to be returned to companies via a reduction in the corporation tax rate.

Stephen Bond, a researcher, called proposals for a lower rate of capital gains tax on long-term shareholding a "really silly idea" as it would have no impact on companies' investment decisions. The IFS also criticised the windfall tax as an unfair levy on current shareholders, as it has before.

But Mr Bond said it would be foolish for companies to challenge the tax in the courts because the impact of future regulatory changes could be far greater. "It would be a brave, or foolhardy, company that would try and sink the Government's flagship," he said.

The Green Budget highlighted pitfalls in some of the proposals for reform of the tax and benefit system. Mr Dilnot said that improving work incentives via the social security system would be expensive.