Taxes don't have to rise after the election

It is very difficult to pick up the economics section of a newspaper nowadays without reading that a large tax increase is "inevitable", if not immediately after the election, then certainly within the next year. The standard line is that the growth of public spending cannot be restricted to the rate set in the 1996 Budget plans, that the public sector borrowing requirement is too high for this stage of the cycle, and that the balance of fiscal and monetary policy needs to be altered so that the upward pressure can be removed from sterling. Once the need for fiscal action has been established, the next stage is to argue that a new government might as well bite the bullet early, following the example of the Howe budget of 1979, which doubled the rate of VAT just 10 weeks after Mrs Thatcher took office that year.

This column has previously argued that the Howe example is a red herring, since the 1979 package did not involve a significant hit to the consumer, but instead switched the tax burden away from income tax and towards VAT. The broad intention to make this switch had been flagged in the election campaign, so the voters did not see the package as a betrayal of trust. But this time, the Labour campaign has in effect said the following: trust us; we are different; the Tories lied to you last time on tax; we see no reason to raise taxation to finance our programme; in fact, we would like to reduce the tax burden on ordinary families.

Obviously, these words should only be eaten if there is an absolutely overwhelming economic case for raising tax immediately. Although in the past couple of years I have usually leaned in the direction of tighter fiscal policy, and still so, I must admit that I do not see the need for higher taxes now as by any means clear-cut. Let us take the main arguments in turn.

First, there is the claim that higher taxes are needed to finance extra public spending. Certainly, it is very difficult to imagine a Labour government - or any government - sticking to the planned growth of only 0.6 per cent per annum in real spending over the next five years, compared with the 1.6 per cent per annum which the Tories have averaged since 1980. But does this mean that taxes need to be raised? Not necessarily. By the end of the next Parliament, Ken Clarke has planned for a budget surplus of 2 per cent of gross domestic product. This, it could be argued, is overkill.

A budget deficit of, say, 1 per cent of GDP would be perfectly feasible, and the difference between these two figures would unlock an extra pounds 27bn per annum for public spending. This is equivalent to 7.6 per cent of the spending total, and if this extra growth were spread evenly over five years, it would take the real growth in spending in the next Parliament to over 2 per cent per annum. Although this might still not be enough, the need for higher taxation to fund expenditure suddenly does not look quite so compelling. (This extra pounds 27bn does, of course, put into context the trivial election debate about a few halfpennies here and there to replace privatisation receipts, reduce class sizes etc.)

The second argument for higher taxes, though, is that a budget deficit of 1 per cent of GDP by the end of the next Parliament is not acceptable, since the economy will by then be working well above its normal capacity, and the PSBR should be more than entirely eliminated in periods of boom. In principle, this is absolutely correct, but on the basis of the Treasury projections, it is not clear that the economy will in fact be above trend in 2002. The Budget Red Book shows GDP returning to trend in 1998/99, and then remaining exactly at trend for the rest of the planning horizon. (In alternative language, the output gap will be zero in those years.)

Clearly, the government should aim to fix the PSBR exactly equal to its long-term objective in years when GDP is at trend. What should this long- term objective actually be? Gordon Brown is committed both to stabilising the public debt ratio, and to achieving the "golden rule" by ensuring that public borrowing does not exceed public investment. These criteria require the PSBR to be 2.5 per cent of GDP, and 1 per cent of GDP, respectively, as an appropriate long-term objective. Thus even on the more restrictive of these two objectives, the budget surplus shown in the Red Book represents overkill, and the pounds 27bn extra spending in 2002 seems feasible.

There is one very important caveat to this conclusion, however. No one actually knows for sure where the true output gap is at any given time. If it turns out that the economy is already working at or above trend, then on the Treasury growth projections, it will remain there for the whole of the planning horizon. This means that the PSBR should be below the 1 per cent target in those years, and that in turn would reduce the pounds 27bn available for extra spending. But we will only find that out in some years' time, when we will have been able to observe whether inflation has started to rise. Until then, we simply will not be able to know for sure whether the underlying budget position really needs to be tightened by raising taxation.

Finally, what about the case for slowing the economy through tax rises rather than higher base rates? Clearly, the consumer does indeed need to be dampened down, and equally clearly higher base rates will push sterling further into overvalued territory. But there are severe doubts about the suitability, and capability, of higher taxes to do the job of base rate increases. Fiscal policy is cumbersome in the extreme, and some economists are very dubious whether temporary changes in taxation, designed to dampen the economic cycle, will have much impact on the spending pattern of rational consumers. They may simply vary their savings behaviour to iron out the impact of tax changes, leaving the path for consumption largely untouched.

Certainly, attempts to model the relative impact of monetary and fiscal policy on economic activity usually suggest that the former dominates the latter. In the present circumstances, the tax change needed to bring consumer spending down to an acceptable rate would be very large indeed. Consumers' expenditure this year is rising at over 4 per cent.

To cut this growth rate to an acceptable 2.5 per cent through raising taxes, the chancellor would need to hike the personal tax burden by more than pounds 8bn in his first Budget, and then hope that consumers did not attempt to thwart him by eating into their savings - or by spending a larger proportion of their pounds 20bn building society windfall this year. So uncertain is the impact of this windfall that there is an overwhelming case for the policy response to be the most flexible possible, and that must mean interest rates, not taxes.

One final point. Even without tax increases, the fiscal stance will tighten by more than 0.7 per cent of GDP next year because of the tightness of the public spending plans. Maybe that is good enough.