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Tax surge boost for the public finances

Soaring VAT payments help take the pressure off government debt as the threat of a bear market recedes
The highest level of VAT receipts since records began meant the public sector paid back much more of its borrowings last month than economists had expected. Gilts initially welcomed the news because the repayment will reduce the number of government bonds in issue but there were also worries that the figures painted a picture of an overheating economy that will require higher interest rates to calm activity.

The pounds 3.875bn repayment in July compared with a pounds 4.64bn deficit in June and a pounds 1.84bn repayment a year ago. It meant the cumulative deficit after four months of the current fiscal year is running at little more than half last year's shortfall. The aggregate deficit of pounds 4.367bn compares with last year's pounds 8.11bn.

There was good news on spending, with departmental outlays up by just 0.2 per cent year on year, suggesting that the restraint seen in the second half of last year continues this time. But most of the good news came on the receipts side, with VAT receipts 32 per cent higher year on year, corporation tax up by 14 per cent and income tax 12 per cent higher, suggesting a limited impact from the introduction of self-assessment for the self- employed.

Although July is normally a favourable month for public sector finances due to large payments of both income and corporation tax, analysts said the number exceeded expectations by some margin. According to David Coleman, economist at CIBC Wood Gundy, the strength was mainly associated with the pick-up in high street spending during the summer as consumers took advantage of windfall payments.

He took a sanguine view of the implications of the figures, adding: "The main consideration for gilt investors should be the improving trend in public finances. It is true that a large part of the falling PSBR is due to the economic cycle, but the latest figures suggest public spending is still subdued."

Jonathan Loynes at HSBC Markets also took heart from the data, which he described as "an excellent set of numbers, which confirm that the public finances are feeling the benefits of the recent acceleration in activity."

He added: "After a disappointing first quarter to the financial year, the PSBR is back on track to meet or even undershoot the official full- year forecast of pounds 13bn."

Geoffrey Dicks, economist at NatWest Markets, also welcomed the figures: "The strength of consumer spending is having a major impact on the cyclical component of the PSBR while public spending restraint is tackling the structural component. Although the markets were expecting a debt repayment this month, its scale has outweighed expectations."

Other economists were, however, less optimistic. Commerzbank economist Chris Barclay said he was surprised to see gilts responding positively to the numbers, given that the major concern for government bonds is how far interest rates may have to climb to quell inflationary pressures.

"Short sterling contracts are suggesting rates are set to peak at 7 or perhaps 7.25 per cent and there is a big risk that this is too optimistic," he added.

Morgan Stanley economist Mark Miller agreed that strong corporation tax receipts and a record VAT contribution were "signs that the pick-up in the economy may harden the monetary outlook for the UK and so have a negative impact".

He warned that the VAT numbers suggest that retail sales data, due to be released tomorrow, could well be strong, boosted in part by the windfall bonuses from building society demutualisations.