View from City Road: Inflation case for more direct taxes

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The Independent Online
The news from Threadneedle Street is that underlying inflation is more likely to stay within its 4 per cent ceiling this year than the Bank of England thought in February, but is less likely to do so next year. Given that the pound is 5 per cent higher, cutting import price rises and hence the inflationary impact of the devaluation since Black Wednesday, this looks odd.

Part of the explanation is that the recovery is proceeding at a faster clip than the Bank thought. But the main reason is the impact of the indirect tax increases (such as VAT on fuel and light) announced in the Budget. They will add just quarter of a point this year, but nearly three-quarters of a point in 1994. Without the tax rises, the Bank estimates that the underlying rate would stay flat at just over 3 per cent next year.

The Bank has unwittingly put its finger on a key problem for government policy. By almost universal consensus outside the Treasury and the Bank, the best course for economic policy, faced by both a large budget deficit and a large current account deficit on the balance of payments, is to keep interest rates and the exchange rate low. The burden of controlling home demand (and hence resurgent inflation) must fall on tighter fiscal policy: spending cuts or tax increases.

As a matter of pure analysis, it is unlikely that the Treasury can deliver such a policy through spending cuts alone, even if that were its political preference. But if tax increases add to inflation, the Government will have to run all the harder merely to stand still. It may also have to contemplate a still higher exchange rate, hitting the trading sectors that can earn our way out of payments deficit.

At some point, the Government must recognise this dilemma and ditch the Thatcherite obsession with indirect tax increases. More of the increase in the tax burden will have to come on direct taxes - income tax and employees' National Insurance contributions - if the Government is to meet its inflation target.