Tax cuts a risk Tories cannot afford to take

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The Deputy Prime Minister has apparently been impressed by confidential evidence linking the electoral performance of governments to the growth in real consumers' expenditure in the 12 months before a general election. Hardly a revelation, one is tempted to say. But it is striking how eager politicians and commentators are to devour new "relationships" between economic variables and political behaviour. Real disposable income, base rates, consumer confidence, inflation, unemployment, the balance of payments - all have been made the central economic variable in explaining voter preferences according to statistical studies in the past 20 years.

Many of these studies unfortunately rest on shaky foundations. I remain persuaded by a "kosher" econometric study conducted a few years ago by David Walton of Goldman Sachs. This showed that once allowance had been made for the electoral cycle - the regular collapse in government support in the mid-term protest season, followed by a sharp pre-election recovery - there was almost no systematic role left for economic variables in explaining government support. Obviously, this is not to deny the general importance of the economy on politics. It is just to deny that its influence is simple or stable enough to be precisely measured. Moods matter, not maths.

Instead of trying to measure the unmeasurable, the Government should worry about devising a clear strategy to maximise its electoral chances. I have been asking acquaintances in the Tory Party what they believe the central electoral strategy is, or should be, for the next 18 months. This tends to elicit blank stares. Either they think the game is already over, or they see no alternative to just ploughing ahead and hoping something turns up.

No doubt the Prime Minister and Chancellor are more focused than this. It seems to me that there are three basic strategies they could follow in the remainder of their term. Let us call them the good government strategy, the tax cut strategy and the base rate strategy. They are not wholly exclusive of each other but they do represent three distinct paths, and the Budget will essentially tell us which the Government has chosen.

The case for the good government strategy is the following: The electorate is a more sophisticated animal than is generally assumed. Voters will not be impressed by a crude pre-election bribe they expect will be reversed immediately after polling day. Furthermore, the financial markets cannot be duped. A reckless economic strategy will simply result in a financial crisis before the election, and this time it will not be credible to blame a collapse on the markets' fear of the opposition. Instead, it will be seen as the final judgement on, and rejection of, Tory policy.

Also, the economic outlook on the good government ticket is not too bad, so maybe nothing much need be changed. The Bank of England's Inflation Report last week pointed out that real earnings for those in work have barely risen during the present economic recovery (see graph), but that the full impact of three years of rising taxes has now been felt. In the next 18 months, real disposable income should rise much faster, and in addition there will be a series of "windfall gains" for the consumer.

These gains will together amount to an incredible pounds 14.3bn, or 3 per cent of disposable income. Since the vast majority of this will come from the proceeds of mergers in the financial services industry, it is not clear how much of the credit will accrue to the Government. But it can scarcely fail to put the electorate in a better mood, and is certain to boost consumers' expenditure in the election run-up.

Nevertheless, it has not been enough to persuade the right of the Tory Party that there is no need for tax cuts before the election. Snatching back the tax card from Labour is, for them, the key to winning the election.

Of course, sizeable tax cuts can be made compatible with the good government ticket if they are genuinely financed from cuts in public spending, with no addition to the Budget deficit. That seems to be what the right of the party wants. They have increasingly demanded large tax cuts almost regardless of the consequences for the public services. And, surprisingly, we have heard barely a squeak from the centre/left of the party, which must surely have some misgivings about the damage to the public services that might be done in the reckless pursuit of tax cuts next year.

The Chancellor and Prime Minister have swung entirely behind the right on this question. If we are to believe press stories last week, the Budget could contain around pounds 5bn of tax cuts, with around pounds 3bn of this being financed by expenditure "cuts". This would involve a 1 per cent drop in real public spending next year, a wholly unprecedented outcome in a pre- election year. Pay bills in the public services would be frozen for another year, capital spending would be slashed in the rather forlorn hope that projects would be financed by the private finance initiative instead, and Whitehall procurement costs would be reduced by some 5 per cent.

No doubt this would make the Chancellor a hero with his party on Budget day. But would such a Budget be compatible with the good government ticket? I rather doubt it, for two reasons. First, there comes a stage where public spending cuts become too large to be plausible, or where they start to do too much damage to the public infrastructure to be worthwhile. This stage may now have been reached. Certainly, large cuts in capital spending next year, with the construction industry in its present parlous state, would be quite straightforwardly the wrong thing to do.

Second, this Budget package would leave the public sector borrowing requirment worryingly high, probably at around pounds 20-22bn (3 per cent of GDP) next year. This would be about pounds 8bn higher than planned last year, even if the spending targets were hit. In the much more likely case that spending overshoots its target, the PSBR really would be much too high for this stage of the economic cycle.

It is mainly because of concerns about the PSBR that it would be better to deviate from the straight and narrow by cutting base rates, rather than taking risks with tax cuts - in orther words, following the third possible strategy. But the received wisdom in the Tory Party is that this would not be an unmitigated blessing, since many of their own activists rely on interest receipts for a large part of their income. In addition, it is thought that Bank of England Governor Eddie George bars the path to sizeable base rate cuts. Anyway, for whatever reason, the political pressure for tax cuts is currently much, much stronger than the pressure for lower base rates.

Until now, the Chancellor has carried conviction when he has argued that the best chance of winning the election is to stick with the good government ticket. But he may now be veering towards the tax cut option, financed by huge but ultimately implausible "cuts" in public spending. The eventual loser would be the health of the public finances.

Let us hope Mr Clarke proves these fears unfounded on Budget day.