These calls for tax cuts are getting out of hand

"Although the Chancellor seems sceptical, the political pressure on him to pull this electoral rabbit from the hat will not abate"

Demands from the right of the Conservative Party for phased income tax cuts, taking the basic rate down to 20p by 1998, are getting out of hand. Not only would such tax cuts be difficult to "afford" within the Chancellor's medium-term targets for the public sector borrowing requirement, but the Tory stampede for political salvation at any price is unsettling the markets.

As explained here last week, the 1993 Budgets have left Britain as the only country in Europe without a severe fiscal headache. But we will never achieve enhanced market confidence if our politicians appear so desperate to reverse the beneficial effects of 1993 at the first glimpse of an opportunity.

The Prime Minister appeared to fan expectations of sizeable tax cuts in his Panorama interview last week. Although the Chancellor seems sceptical, the political pressure on him to pull this electoral rabbit from the hat will not abate, and there will be great bitterness if he fails.

The political case in favour of this phased programme is obvious. Both in 1987 and 1992, the Government effectively skewered the opposition by promising to implement income tax cuts immediately after the election, thus offering Labour the choice between being a "me too" party, or the party of tax rises. Labour fell exactly between the two stools, and impressed nobody.

There is a school of thought in the Tory Party that the same trick will not work thrice, since Labour has this time seen it coming. Indeed, the weekend press has reported that Tony Blair is ready to commit Labour to implementing any tax cuts the Tories promise, both before and after the election. In 1997, the question for the electorate will be: who do you really believe will implement their promised tax cuts - the Tories, after their 1993 U-turn, or Labour, which still has a left wing that is calling for tax rises? It is not obvious that the Tories will lose this argument.

The budgetary arithmetic, though, is problematic. There is a tendency to assume that there will be automatic scope for large tax cuts in the next few years, created by a continuing economic recovery. On inspection, this cannot be relied upon. Not only might the recovery falter; even if it does not the fiscal arithmetic looks tight. In the 1994 Budget, the Treasury estimated that, on the basis of 2.75 per cent annual growth in real GDP, the PSBR would shrink from £34bn in the current financial year to zero by 1998-99.

The Chancellor has stated often that his objective is to achieve budget balance - zero PSBR - when the economy has returned to normal. The implication of the 1994 Budget was that 1998-99 should be the target period. There is therefore no margin for tax cuts by 1998-99, even though the Treasury is assuming that the real level of public spending will rise by only 1 per cent per annum in the next four years. If achieved, this would reduce the share of public spending in GDP from 43.5 per cent this year to 40.5 per cent in 1998, but the benefits would be allocated to lower public borrowing, not to lower taxation.

Where is the scope for tax cuts in this scheme of things? On the face of it, there is none. But the Treasury is good at creating fiscal room for manoeuvre when necessary. There are three possible routes. First, growth in real GDP might be more rapid than the Treasury has assumed. But there is no indication yet that growth in 1994 or 1995 has been any higher than forecast, and it is hard to see how the Treasury could credibly pencil into its medium-term forecast an average growth rate any higher than 2.75 per cent. Certainly, it could not do this while maintaining a commitment to inflation of 2 per cent at the end of the period. And there is another point here. If the economy really does grow by more than 3 per cent per annum over the rest of the decade, we should not repeat the mistakes of the late 1980s by throwing the fuel of tax cuts onto an already raging fire.

The second possible route would be to cut the growth of public spending still further. But it is doubtful whether this would carry credibility in the financial markets. Admittedly, the control of spending in the past two years has been good, with the total tending to undershoot published plans. Experience suggests, though, that it will be difficult to keep the lid on public sector pay, especially in a pre-election period. Three years of real growth in public spending would be needed to create room for a 20p basic rate of income tax by 1998-99. Not plausible, m'lud.

This leaves the third route, which is to abandon the balanced budget objective, and to permit a higher PSBR over the medium term than previously targeted. This would not be laughed out of court, since a balanced budget, when the economy is at normal capacity, is a tough target - tougher than would be needed to stabilise the ratio of public debt to GDP. The Chancellor could consider easing this objective. If he decided to reduce the PSBR by only the amount required to stabilise the debt ratio by the end of 1998-99, he would create an extra £17bn of scope for tax cuts over this period - more than enough to achieve the desired 20p income tax rate.

However, it would be difficult to think of a good reason for changing the objective for the PSBR without appearing to be engaging in crass electioneering. If the Chancellor had set an ultimate PSBR target of 2 per cent of GDP a year ago, almost no one would have quarrelled with it, since most independent economists have argued that this is tough enough to attain fiscal sustainability. But having set himself a tougher target, arguing that the Government should be aiming to reduce the debt/GDP ratio when the economy is not in recession, the Chancellor will now have considerable difficulty in wriggling out of his self-imposed straitjacket.

It is therefore quite hard to see how the Treasury can find the scope to reduce the basic rate to 20p by 1998 without tearing up the pledges made on Budget targets last November. Of course, a 20p rate would be attainable if the Government really were ready to freeze public services for three years or to finance cuts in the basic rate of income tax by raising revenue elsewhere (for example, by restricting the value of income tax allowances still further). But then there would be losers as well as gainers from the tax cuts, and the political advantages would be much less clear-cut. All in all, there may be a smaller electoral rabbit in the Chancellor's hat this November than many in his party expect.

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