The logic behind Green Budget's conclusions

`It would be worth betting a pound to a penny that the spending totals included in the first Brown Budget will not deviate an inch from the commitments given in opposition, which in effect means that the Chancellor has already chosen to tighten fiscal policy through public spending restraint'

The Green Budget published by the Institute for Fiscal Studies and Goldman Sachs received considerable press attention last week, with some of it criticising the main conclusion of the document - that the case for significant consumer tax increases in the summer Budget is not proven. For example, the Financial Times made several important points, notably that Gordon Brown should make use of Labour's huge Parliamentary majority to "seize control of the public finances, decelerate growth to a non- inflationary rate, and so reduce the need for damaging interest rate rises". It added in censorious tone that "if he fails to act, there is a real danger that inflation could be let out of the bag".

In previous years, the Green Budget has itself argued in favour of tax increases on related grounds, so we certainly do not rule such arguments as being completely out of court. However, we stopped making this case around 1994, by which time our calculations suggested that the structural budget problem in the UK had been largely solved, and that the fiscal/monetary mix had been rebalanced. We never argued that fiscal policy should be used as the main weapon in short-term demand management, and have never seen tax policy as suitable for the short- term control of the economic cycle.

Furthermore, the FT's assertion that fiscal policy should be responsible for the control of inflation in the UK is very odd indeed. After all, the FT itself has recently welcomed the fact that the responsibility for hitting the inflation target has just been handed over to the independent Bank of England, thus making it apparent that inflation is a monetary phenomenon, not a fiscal phenomenon. There is no evidence whatever that the size of the budget deficit is related to the inflation rate in developed economies, where central banks are prohibited from monetising the government's need for funds.

What is true is that a more expansionary fiscal policy will inevitably increase the work to be done by monetary policy to slow the economy, and we would freely acknowledge both that this is the case, and that it raises severe headaches for policy makers. However, the key new point made by the Green Budget, which is still steadfastly ignored by many commentators, is that the budgetary baseline which Mr Brown has inherited already contains a very significant fiscal tightening.

It sometimes appears that many people have decided to argue for more budgetary action from wherever we happen to be starting, regardless of how much tightening has already been built into the baseline. This is akin to the mistake which is often made in the setting of monetary policy, whereby people argue in favour of higher base rates whenever bad inflation news is published, forgetting to take account of the degree of stringency already in the pipeline from previous measures. The consequence is that policy tends to move belatedly, and then by too much.

The table shows how much fiscal tightening is already in the budget baseline for next year. The over-indexation of excise duties announced by Ken Clarke will contribute an additional pounds 1.5bn to the tax take in each year during this Parliament, cumulating to a total tax increase of about 1 per cent of GDP in a full Parliament. (Incidentally, this tax rise is likely to be as invisible to the electorate as a tax change ever gets - can anyone really tell the difference between a 3 per cent price increase in petrol each year, and an 8 per cent increase, given the degree of price competition at the pumps nowadays?)

Next year, an extra pounds 1bn will be derived from other tax changes, and pounds 3bn more will come from real fiscal drag, the process by which the tax burden rises each year as a result of higher real incomes.

Finally, another pounds 3bn or more comes from the decline in planned public spending as a share of national income. That makes pounds 9bn in all, which is surely enough to be going on with.

It is just about understandable that even higher tax increases might be demanded by people who wish to raise the level of public spending relative to the plans which the Conservatives have bequeathed to the new government. It is at least coherent to argue that the baseline for spending, built into the above calculations, is too low to enable the Government to satisfy the demands of the electorate for improved public services.

However, this does not happen to be the approach taken by Mr Brown, at least for the first two years of the Parliament. It would be worth betting a pound to a penny that the spending totals included in the first Brown Budget will not deviate an inch from the commitments given in opposition, which in effect means that the Chancellor has already chosen to tighten fiscal policy through public spending restraint.

So while it may be coherent to ask for both tax and spending to be increased, it is certainly not coherent to demand that Mr Brown should stand up and say: "Here are my spending commitments, but just in case I don't meet them in the next year or two, here are some tax increases as well."

Later in the Parliament, when Labour has had time to re-assess spending priorities, it is perfectly possible that spending totals will be increased. It may even be the case that taxation will need to be raised at the same time, depending on the behaviour of the PSBR in the meantime.

But at least the voters will then see what they are getting for the extra tax, and the causes of higher tax will have nothing to do with a cyclical need to tighten the fiscal stance.

It is interesting to contrast the state of this debate in the UK today with the situation in the US, where the economy is in roughly the same cyclical state. Across the Atlantic, it would never occur to anyone to argue that consumer taxes should be used as a cyclical economic regulator. It would be taken absolutely for granted that this is the job of the Federal Reserve. In fact, US Treasury Secretary Bob Rubin has welcomed the recent rise in the dollar on the grounds that it will dampen inflationary pressures in the domestic economy.

It is very difficult to imagine anyone in the UK welcoming the rise in sterling on these grounds, yet it is hard to understand why the conventional wisdom in Britain should be so adamant that it is better to use the personal sector as the main economic regulator rather than the foreign trade sector.

This may or may not be the case, depending on the ability of the two sectors to absorb variations in income by varying their financial flows. It is certainly not axiomatic that the personal sector should find it any easier than the foreign trade sector to do this - in fact, the reverse may well be true.

One last point. In order to reduce the upward pressure on base rates by one percentage point, the level of consumer taxes would need to rise by pounds 8bn to pounds 9bn a year, according to rules of thumb from macro-economic models. Hands up anyone who is seriously arguing for this.

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