The International Monetary Fund called on the Government yesterday to cut spending rather than raise taxes to avoid breaching its own golden rule.
In its annual snapshot of the UK economy, the IMF warned the fiscal position had "deteriorated significantly" in recent years. It urged Gordon Brown to act quickly rather than pin his hopes on an increase in tax revenues.
The report came one day after official figures showed public borrowing so far this financial year had spiralled to a 10-year high. Economists warned the Chancellor would need to raise taxes by £10bn a year - the equivalent of 3p on income tax - to fill the looming black hole in the nation's coffers.
The IMF said: "We would favour an approach that relies on spending restraint - both to reduce the current risks of running into limits on absorptive capacity and to allow more time to assess value for money."
It warned that government projections for UK public finances looked too optimistic - pointing to a "recent history of optimistic revenue projections". However, it did say the Chancellor was on course to meet his so-called golden rule - which forbids him from borrowing except to invest - over the current 1999 to 2006 economic cycle.
It added: "Considerable uncertainty about the course of revenues over the medium term has heightened the debate about whether current policies will return the fiscal accounts to a sustainable position consistent with the Government's fiscal rules." It expects lower revenue growth, reflecting "slower real GDP growth in 2005 and a less pronounced rebound of corporation tax revenue".
The fund believes Mr Brown has overestimated GDP growth in the 2005/06 financial year. It predicted GDP growth would slow to 2.5 to 2.75 per cent, compared with the Chancellor's prediction of 3 to 3.5 per cent.
It called on the Government to press ahead with "mild fiscal adjustment", adding: "The fiscal position deteriorated substantially in recent years, and questions are emerging about how and when the necessary correction will take place.... Early adjustment would significantly reinforce the credibility of the fiscal rules."
Last month, government spending spiralled by 7.3 per cent after it concentrated all its winter fuel payments in one month. Since income from taxes only rose by 4.9 per cent, the Government was forced to borrow £9bn to plug the gap.
The Treasury is banking on a surge in revenues from North Sea oil tax receipts. The IMF said that if tax hikes were unavoidable, "broadening the tax base would be preferable to raising tax rates, given potential adverse effects on supply".
A separate report issued today echoed the IMF's views. The latest estimates by the Centre for Economics and Business Research warned that "tough fiscal decisions" would be needed after the next election. "Slower public spending growth or higher taxes and possibly both are likely to be required after the election," it said. The report said that without a "fiscal tightening" the public finances would show little improvement until 2008, predicting that if Labour formed the next government it would need to increase council tax by 8 per cent a year and add 2p to national insurance contributions.
Douglas McWilliams, the chief executive of the CEBR, said neither Mr Brown nor Oliver Letwin, the shadow Chancellor, "will be wholly happy with the prediction that the fiscal position is likely to continue to deteriorate over the next four years".
The IMF reiterated its central forecast for a "modest decline" in house prices over the coming year - one of the key downside risks to the growth outlook that it has identified.
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