Markets fear a lurch on taxes

After the weekend, during which it became apparent that John Major's leadership gamble could backfire disastrously, markets are expected to focus on the political risk that the election will bring about a lurch towards a loose economic policy.

The fear is that any successor to Mr Major will push the boat out still more on tax cuts when the strain on public finances is still immense.

The Treasury's summer economic forecast on Wednesday is expected to lift its estimates for the PSBR by pounds 3bn for both the current fiscal year and 1996/97.

With Michael Heseltine seen as the favourite to win if Mr Major has to retire wounded after the first round, the City is pencilling in even bigger tax cuts for next year.

"There is no doubt that markets regard Mr Heseltine as a less fiscally prudent guy," said Stephen Bell, chief economist at Morgan Grenfell, which has doubled its forecasts for tax cuts in the November Budget to pounds 4bn.

David Walton, of Goldman Sachs, said: "Whoever wins, there is a significant risk that policy will be held inappropriately loose over the next two years."

Mr Walton believes that the gilt/bund spread will widen out to 180-200 basis points in the coming months and that sterling will drift lower.

The trouble is there is now even less room for tax cuts than appeared likely when the Government last made its official forecasts at the time of the Budget. In November, the Treasury predicted a PSBR of pounds 34.4bn for 1994/95 and pounds 21.5bn for this year.

Since then, however, the improvement in the public finances has begun to falter. Last year's deficit of pounds 35.6bn overran the forecast by pounds 1bn, and the first two months of this year have already seen a deficit of pounds 8bn.

The problem lies on the revenue rather than on the expenditure side. After a shortfall in tax of pounds 3bn in 1994/95, receipts are continuing to disappoint in the current fiscal year. In particular, VAT is coming in lower than expected, partly because of the export-led nature of the recovery - exports are zero-rated - and partly because of the stagnation in retail sales.

Against this background, the increase in the PSBR forecast to pounds 24.5bn that the Treasury is expected to announce on Wednesday for the current year, will simply bring it into line with the majority of City houses.