Revenue shortfall will not stop budget tax cuts
So when he announces in public that he is serious about hitting the inflation target by the end of the Parliament, this should not be dismissed lightly. And when he says that tax cuts will happen only when "Britain can afford them" - as he has repeatedly claimed ever since moving into Number 11 - this too should be taken at face value.
This November's Budget will be something of a test for the Chancellor's veracity, since it is far from clear that sizeable tax cuts can be "afforded" in the sense that he usually uses that term. Affordability, in the Chancellor's thinking, is judged entirely by reference to the path for the PSBR, which he has consistently said has been far too high in the past few years.
In the 1994 Budget, mainly by cutting his public spending targets in line with declining inflation, and by eschewing tax cuts almost completely, Mr Clarke was able to impress everyone by unveiling a much-faster return to budget balance than had been envisaged previously.
But this year, his task looks far more difficult. The PSBR figures published so far in 1995-96 are suggesting that a large over-run in public borrowing is now taking place. The graph shows that in the early part of the financial year the monthly pattern for the PSBR has been no better than last year, when the eventual out-turn was pounds 34bn - well above the "affordability" threshold for tax cuts. Latest estimates at Goldman Sachs suggest that some improvement in this pattern is to be expected over the remainder of the year, but the out-turn for the PSBR in 1995-96 will still be about pounds 27bn, much higher than the original target of pounds 21.5bn.
So far this year, public spending has been roughly on target, but a serious shortfall has developed in most areas of Government revenue, which at present is running at an annual rate of about pounds 8bn to pounds 9bn below Budget expectations. Some of this seems to be because of the timing peculiarities affecting corporation tax and excise duties, which should be reversed in the remainder of this year. But this could still leave an eventual shortfall in receipts of about pounds 5bn.
Why has this happened? Much of the revenue shortfall is the result of a one percentage point drop in inflation, compared with the rate assumed by the Treasury last November. Meanwhile real GDP has dropped by only about 0.5 per cent, nowhere near enough to explain the full overshoot in the PSBR. It follows by definition that the underlying fiscal stance has been eased, compared with last year's plans.
Furthermore, according to the Treasury's 1995 Summer Forecast, a pounds 5bn shortfall in tax receipts is expected to continue next year, despite the fact that both real and nominal GDP are, by then, assumed to have bounced back to the levels shown in the Budget projections. With both prices and output likely to be approximately unchanged from the Budget assumptions, any increase in the PSBR above the levels planned for next year (pounds 13bn) would, of course, once again amount to an easing in the underlying fiscal stance - something that the Governor of the Bank of England, to name but one, might not like.
Since the Treasury expects revenue to drop pounds 5bn below previous targets next year, it follows that they would need to shave the same amount off public spending in order to leave the PSBR unchanged. Is that feasible? In the 1994 Budget, the Treasury managed to slash public spending in the year ahead by pounds 8bn, so on the face of it a pounds 5bn reduction does not look out of court. But the main reason for lower public spending last year was a simultaneous large improvement in both real GDP and inflation - a windfall that meant public spending could be reduced without any real pain being felt by those who rely on the public services.
This year, a large cut in spending would be much harder to achieve, since the underlying behaviour of the economy has not changed in such an advantageous way. In fact, even to hit previous public spending plans, the real level of spending will need to drop by about 0.7 per cent next year - an outcome which would be quite extraordinary in a pre-election period.
The Chancellor therefore faces the following tricky dilemma. He is probably being told by his officials that revenue could undershoot previous plans by about pounds 5bn, producing a PSBR projection of pounds 18bn in 1996-97, instead of pounds 13bn. In order to hit the original PSBR target, Clarke once again needs to find a tidy sum in spending cuts. During his leadership campaign in June, John Redwood claimed, ludicrously, that pounds 5bn could be found from cutting bureaucracy in Whitehall, and this sent the right wing of the Conservative Party into a renewed frenzy for cutting "waste". But, in reality, to remove pounds 5bn from the spending figure will hit the real provision of services extremely hard in a pre-election year, and that will not be at all easy to railroad through the Cabinet.
So what is the solution? The obvious one is to relax the PSBR target by several billion pounds. Remember that all the comparisons we have reported so far have been relative to the sharp annual falls in the PSBR which were planned last year. The fiscal stance has indeed been eased during the current year, relative to the plans for 1995-96 announced a year ago, and the same seems set to happen next year. But the baseline against which we are comparing the new projections is a very tough one, with the fiscal stance being tightened meaningfully from one year to the next, largely because of tough control over public spending.
Thus, if the Chancellor decides to relax last year's PSBR guidelines a little, all this will mean is that the fiscal stance, from one year to the next, will tighten a little less than previously expected. Last year, the Chancellor donned a very tight corset. He can afford to let it out a bit this year, and still cut a trim enough figure on his big day in November.
The Budget package could therefore look something like this. Last year's Budget, as we have seen, foreshadowed a PSBR target of pounds 13bn in 1996-97. About pounds 5bn will be added to this for the revenue shortfall. But the Treasury might be able to find some new spending cuts, say pounds 3bn, which would take the PSBR to pounds 15bn. If the Chancellor were finally to add pounds 3bn to the figure by announcing a small package of tax cuts, he would leave the PSBR at pounds 18bn - about 2.5 per cent of GDP, only half of last year's level, and comfortably the lowest level of public borrowing in Europe.
Admittedly, the target date for eliminating the PSBR altogether would be put back a year to 1999, but it would be hard to find anyone sensible who would really care. Those with an eye for the big picture would see that the years of budget austerity had worked, and that a small reward was by now understandable.
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