Taxing questions about the UK's fiscal policy

Internet users are familiar with the FAQs - frequently asked questions - attached to cyberspace discussion groups. I am not aware that a discussion group exists on British fiscal policy, 1996-2000, but if it did, the following would be the FAQ section.

Is the public sector borrowing requirement still overshooting its targets for this year?

Yes, but the situation now seems to have stopped getting worse. In the 1995 Budget, the Chancellor, Kenneth Clarke, set a target of pounds 22.4bn for the PSBR this year. By the Summer Economic Forecast in July, he had increased this to pounds 27bn, with much of the excess due to a shortfall in VAT and other taxes. Recent monthly figures for the PSBR have been very volatile, but the intense rise in consumer spending should fill the Treasury coffers from now on. The Green Budget published last week by Goldman Sachs and the Institute for Fiscal Studies reckons the eventual out-turn for the PSBR this year will be about pounds 26bn.

What about next year?

Once again, the Chancellor will miss the PSBR targets he set in the November 1995 Budget by a wide margin. At that time, he announced plans intended to reduce the PSBR to pounds 15bn in 1997/98. But disappointing growth in the economy seems to have scuppered this, and the likely out-turn on unchanged policy now seems to be around pounds 21.5bn. Thus, if the Chancellor were really wedded to his previous PSBR objectives, he would raise taxes (or cut public spending) by pounds 6.5bn this November.

Not even Mr Clarke would do that, would he?

Of course not. He is not crazy. Instead, he will simply increase the target for the PSBR next year, and hope that no one notices. After all, this is exactly what he did last year, and no one really complained then. He can pull the same trick again this year.

So are the Government accounts on a Rake's Progress?

It is not really as bad as that. The PSBR this year will be 3.5 per cent of GDP, which is admittedly far too high to maintain on a permanent basis. According to the Golden Rule of public finance, espoused by both Mr Clarke and Gordon Brown, the government should borrow no more than it invests over the long term. This suggests that the PSBR should average around 1 per cent of GDP, which also happens to be the target set in the Stability Pact being prepared for future members of EMU. Even if we choose to stay out of the single currency, the financial markets will require that we follow the same principles of sound finance that apply within EMU.

This means that the markets will be scrutinising the Budget to see whether it is likely to reduce the PSBR to around 1 per cent of GDP on a trend basis, even though this target will not be achieved by 1997/98. This year's Budget Red Book will indeed show plans which accomplish this by the end of the decade.

Why should the markets believe this pie in the sky when the PSBR overshoots targets all the time?

There will indeed be a great deal of justified scepticism about this. But there are two points on the Treasury's side. First, the economy is probably still working some 1-3 per cent of GDP below its normal capacity, since the spare capacity created in the recession of the early 1990s has not yet been eradicated. As output returns to its normal trend, there should be an automatic increase in tax receipts which will reduce the PSBR.

Second, the Government is intending to severely restrict the growth of public spending over the medium term, with the control total rising in real terms by only 0.5 per cent per annum. The share of spending in GDP will decline if these plans are hit, bringing the PSBR down over time.

Does that mean that the PSBR will fall to the acceptable level of 1 per cent of GDP when the economy is next on trend?

That indeed is the crucial question. Obviously, the greater the degree of spare capacity in the economy today, and the tighter the control of public spending in the future, the more likely it is that this target can be hit. At the most optimistic end of the spectrum, with 3 per cent of spare capacity today, and the Government achieving its public spending plans in the future, the PSBR would decline to zero by the time the economy returns to trend in 1999.

But if today's spare capacity is only 1 per cent, and the public spending plans cannot be hit, then the PSBR will still be around 3 per cent of GDP when the economy hits trend - much too high. Fiscal plans should be set on a conservative basis, so there should not be any net tax cuts this year. Later, if tight control over spending can be maintained, it is possible that scope for tax cuts may emerge. This, of course, is not what Conservative election candidates want to hear.

What are the chances of hitting the Government's spending targets?

Recent experience is quite encouraging, with the real control total rising by an average of only 1 per cent per annum since 1993/94. But this period of tight spending control came after the bulge of 1992/93, when real spending surged by 6 per cent in a single year.

Experience over longer periods suggests that spending on health and education must rise at least in line with real GDP. Indeed, since people want relatively more of these services as their incomes rise, the demand for them will inexorably rise more rapidly than real GDP. And the scope for cuts in other areas of spending - mainly defence and capital investment - has been largely exhausted already. This means that if the spending targets are hit, the electorate is likely to be aggressively unhappy about its health and education provision in five years' time.

The only alternatives would seem to be to increase spending much more than planned, or move away from the principle of universal free provision at an adequate level for these services. After all, that is what the Tories did to pensions in the 1980s. The real issue for the public finances in the next Parliament will be whether to bite this bullet. If it is not bitten, then spending will inexorably exceed targets, and tax cuts will not be possible. Indeed, tax increases would be quite likely.

How much of this will become apparent in the Budget?

Absolutely none at all. Mr Clarke will probably cut income tax by pounds 3- 4 bn, and justify this by claiming that he is cutting a similar amount off public spending in 1997/98. This will in effect repeat last year's Budget package, and will enable the Chancellor both to reduce the basic rate of income tax by 1p and to widen the 20p band by up to pounds 1,000. It would not necessarily be a wise budget, since a large chunk of the spending cuts required to finance the tax giveaway would either be temporary, or come in the area of capital spending. But the resulting problems would be a headache for the next Chancellor, not the present one.