Lamont expected to put off raising taxes until December: The Green Budget examines the dilemma facing the Chancellor. Robert Chote reports on the economists' conclusions

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The Independent Online
NORMAN LAMONT faces one overwhelming dilemma in his March Budget. Should he start to tackle the gaping hole in the Government's finances by raising taxes or hold fire for fear of jeopardising recovery?

Goldman Sachs and the Institute for Fiscal Studies expect him to do the latter. Their annual Green Budget predicts that tax increases will be delayed until December's Budget, the first to combine tax and spending decisions.

Yesterday's surprise cut in base rates has pushed most City economists towards the same conclusion. The Government is not yet convinced that a recovery is safely under way and is unlikely to risk devastating confidence by raising taxes prematurely.

But the Green Budget concludes that the nettle will have to be grasped in December, and that taxes are then likely to be increased by pounds 5bn- pounds 6bn. The most likely candidates are an extension in the range of goods on which VAT is paid or an increase in national insurance contributions.

One problem with extending VAT to food, fuel, books, newspapers, transport and children's clothes is that it hits the poor hardest. But pounds 5bn of extra revenue could still be raised, even if benefit increases fully offset the distributional impact.

Higher income tax rates are thought to be politically unacceptable, but pounds 970m could be raised by failing to increase tax allowances and thresholds in line with inflation. A rise in national insurance contributions has virtually the same effect as raising income tax rates, but would be politically more palatable.

More radical sources of revenue could include environmental taxes, such as the EC's proposal for a carbon tax or higher taxes on petrol. People could also be made to pay for public services, such as roads, that had previously been funded by taxation. More private sector funds could also be attracted into state projects, such as hospital building.

Imagination will certainly be needed. The Government is looking for perhaps pounds 20bn in the next few years to repair public finances. With little scope to cut public spending, the burden will fall almost entirely on taxes.

The Green Budget argues that the Chancellor can risk tax increases only after a further boost to recovery from lower interest rates - especially if uncertainty about future tax changes is another drag on spending.

Cuts in interest rates should also increase the international competitiveness of British goods by weakening the pound. This should help to stop an unsustainable widening in the trade deficit from halting recovery.

The shortfall between tax revenue and public spending will force the Government to borrow pounds 38bn during this financial year, according to the Green Budget.

This is in line with the Chancellor's Autumn Statement forecast, but pounds 10bn higher than his prediction in last year's Budget. The widening since then reflects the unexpected deepening of the recession. Social security benefit spending is higher than forecast, while VAT, income tax and corporation tax are yielding less than expected.

The Green Budget forecasts that the public sector borrowing requirement will then rise to an 'abnormally high' pounds 54bn in 1993/4. This is pounds 10bn more than Mr Lamont projected in the Autumn Statement, despite being based on an economic growth forecast more optimistic than that of the Treasury.

Most economists accept the justification for high government borrowing during times of recession. The case for tax increases arises more from the likely trend over the rest of the decade. Will 'structural' borrowing remain after economic recovery has boosted tax revenues and cut benefit spending? And will the debt be financeable in the meantime?

The pounds 54bn PSBR in 1993/4 would amount to 8.75 per cent of national output, a figure last seen in the mid-1970s. The PSBR is likely to remain above pounds 50bn until 1997/8 if the economy grows by 3 per cent a year, and to widen to more than pounds 80bn if growth stabilises at 1.5 per cent.

'It is obviously far higher than anything which might be consistent with a sustainable path for public debt, so there is no question that the PSBR must be brought down sharply over the medium term'.

The first victim of the new realism is likely to be the Government's stated target for fiscal policy: to balance its books on average as the economy strengthens and weakens.

'A reasonable long-term objective for the public finances would be to stabilise the ratio of public debt to GDP, once the economy has returned to full-capacity working'. This implies a PSBR in a normal year of 3 per cent of GDP, about pounds 21bn by the mid-1990s.

The size of the tax increases needed to achieve this objective depends on how far the economy is running below full capacity. The Organisation for Economic Cooperation and Development estimates that the gap is now 7 per cent. If the economy grows by 3 per cent a year from 1994/5 - and its trend growth rate is about 2 per cent - this implies a return to full capacity in 2000/01.

This scenario requires a tax increase of 2.25 per cent of GDP at some point to bring the PSBR down to its 3 per cent target. While this does not appear too onerous, it would imply a ratio of debt to GDP of more than 70 per cent by the end of the century and an annual bill for debt interest of 6 per cent of GDP.

But what if the OECD is overestimating the amount of spare capacity in the economy, because of company failures and the scrapping of capital equipment? With a smaller gap to be made up, the economy would return to capacity by 1997/8.

That would leave an entirely structural PSBR of just over pounds 50bn in that year, implying that tax increases of 3.5 per cent of GDP - nearly pounds 25bn - would be needed to get the PSBR back to the target of 3 per cent of GDP.

----------------------------------------------------------------- THE PUBLIC FINANCES: The Medium-Term Outlook ----------------------------------------------------------------- pounds bn 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 Inland Revenue 75.7 77.1 82.5 89.2 97.4 106.0 Customs and Excise 63.4 65.5 68.7 72.5 76.4 80.6 Total taxes and royalties 161.0 165.4 174.6 185.9 198.8 212.3 General government receipts 222.2 226.5 240.3 256.6 273.1 290.4 Control total 232.0 243.8 253.5 263.2 273.0 282.0 General government spending 268.7 286.8 303.0 316.7 330.0 342.0 Privatisation -8.0 -5.5 -5.5 -1.0 -1.0 0.0 PSBR 37.8 53.8 56.2 58.1 54.9 50.6 ----------------------------------------------------------------- Source: IFS -----------------------------------------------------------------

(Graphs omitted)

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