Taxes should rise

There has been a subtle but significant change in the Government's approach to budgetary policy since Ken Clarke took up the Treasury reins three weeks ago. In Norman Lamont's final interview in office - conducted by all accounts before he knew he was about to be sacked - the outgoing Chancellor made it clear that he would increase taxes again in the November Budget unless the Cabinet agreed to significant cuts in public expenditure this summer. A further dose of decisive action by the Government was, he believed, necessary to get the budget deficit down.

Superficially, it may not appear that Mr Clarke has yet changed this message very much. He has described the public sector borrowing requirement as an 'iceberg' in the way of the recovery, and his Mansion House speech repeatedly emphasised the need to bring it down. Yet beneath the surface things are changing.

On public spending, for example, Mr Clarke talked of the need to stick within existing targets, but said nothing about reducing spending below those targets. Any cuts in the welfare state which emerge from the Portillo review will simply offset increases elsewhere. This approach, which the Cabinet appears to have endorsed last Thursday, will permit the real level of general government expenditure to increase by 1.5 per cent next year, and by an average of about 1 per cent in the following two years.

This may not sound much, but coming on top of real spending growth above 5 per cent in each of the past two years, it is in fact quite generous. As usual, the government press machine is describing the Cabinet's summer spending exercise as 'the toughest for 15 years'. As usual, this is so much hot air.

Despite this total absence of spending cuts, Mr Clarke already seems far less willing to contemplate tax increases than his predecessor. The Mansion House speech said that 'we cannot rely on recovery alone to bring borrowing back towards balance'. This appeared to suggest that new fiscal measures would be required. But with his very next breath, Mr Clarke explained that the measures he had in mind were those already announced by Mr Lamont in the March Budget. Nothing more is promised, or indeed threatened.

This softer line on the Budget is easy to understand. Senior ministers know only too well that the Treasury's medium-term projections for the PSBR (like everyone else's) are subject to huge margins of error.

So here is a government pondering whether to risk political Armageddon in order to introduce budgetary measures worth only a few billions - a mere drop in the bucket compared with the oceans of error potentially contained in the Treasury projections. The PSBR problem has become so big that it will either be solved by growth in the economy or it will not be solved at all.

This seems to be what the Prime Minister meant when he claimed recently that 70 per cent of the present level of the budget deficit is directly attributable to the recession. Last time he made a similar claim there was consternation in the Treasury about where this figure had come from. There was also some tut- tutting about the obvious implication of Mr Major's remark, which is that 70 per cent of the deficit will solve itself once the recession ends. His arithmetic does seem to err a little in an optimistic direction. This year GDP will be about 7 per cent below the level it would have reached if pre-1990 growth trends had persisted. Standard models show that a recession of this depth should have automatically increased government borrowing by about 4- 5 per cent of GDP, thus explaining only about half of the present PSBR, not the Prime Minister's 70 per cent.

But a more important objection to the Prime Minister's argument is that not all of the 'cyclical' element of the PSBR will disappear as the economy recovers. This is for two reasons. First, past experience has shown that recessions trigger a culture of state dependency in some people who initially move on to unemployment benefit, but then transfer more permanently on to sickness, disability or supplementary benefit. These payments do not melt away as activity recovers.

Second, the economy has almost certainly wiped out part of its physical capacity as plants have been scrapped in the recession. The quality of the labour force has also been eroded as unemployed workers lose motivation. The Prime Minister's arithmetic seems to assume that none of this has happened in the past three years, which is highly optimistic.

These arguments seem unlikely to wash with a cabinet eager to avoid more unpleasant medicine in November. But there are other reasons, not directly connected with the PSBR, for increasing the burden of taxes on the consumer in the next few years.

As Wynne Godley has been arguing for some time, the share of personal consumption in GDP is extremely high - around 66 per cent, compared with a long-term average of about 60 per cent. Consumption is, of course, a highly desirable end- product of a successful economy, but a short-term consumer bonanza, won at the expense of exports and investment, is not a good idea.

We now need to shift resources back out of short-term consumption (public as well as private) and into exports, training, education and investment in plant and equipment. The best - indeed only - way of encouraging this shift is to keep interest rates relatively low, hoping that the real exchange rate will remain at or below present levels, but at the same time to increase substantially the burden of tax on the consumer.

I would suggest raising consumer taxes (or reducing public consumption, if this is feasible) by around 2- 3 per cent of GDP by the end of this parliament, phased in gradually over the period. About half of the proceeds should be used to reduce the PSBR, with the rest devoted to special measures to improve the infrastructure, training programmes and help for the long-term unemployed.

This programme would reduce the PSBR to the Maastricht limit of 3 per cent of GDP by 1997/98, and would probably eliminate the risk of a balance of payments crisis ahead of the election. It might even start to reverse the long-term decline of the economy. But I am not sufficiently nave to believe that it would be politically easy for this government to introduce - or indeed for the Opposition to espouse.

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