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Just when you thought things were looking up ... er, they’re not

The economy may be recovering but tax revenues aren’t. This is a mystery, with no happy ending

The economy’s up; but government tax revenues are down. What’s going on? Well, something very big may be going on but we don’t know for sure. What we do know is this. The economy is growing by around 3 per cent a year, maybe rather more to judge by the rate of job creation. There are 800,000 more people at work than there were a year ago. Retail sales are well up, by 3.9 per cent year-on-year, and consumers are more optimistic than at any time in the past nine years. Given all this, you would expect tax revenues to be about 5 per cent higher – growth of 3 per cent plus inflation of 2 per cent – and the Office for Budget Responsibility projects that revenue this financial year will be up 5.3 per cent.

However, we learnt last week that revenues for the first two months of this financial year were down by 3.4 per cent on the same period in 2013. Total current receipts were £92.3bn, versus £95.4bn in April/May last year. VAT receipts are fine, up 5.7 per cent, and that would square with strong consumption, and corporation tax is up too. But income tax and capital gains tax are down 4.7 per cent and National Insurance Contributions (NICs) are down 2.2 per cent. This is not what is supposed to happen, particularly since tax revenues have in the past been particularly strong in the early and middle stages of an economic recovery.

There are three possible explanations, and I guess the answer will be a bit of all three. The first is that the figures are wrong. We may be undercounting income tax and NICs for some reason that is not yet clear. There have certainly been problems with PAYE assessments and these may be carrying through to this year. As for national insurance, it is pretty odd that this source of revenue is going into reverse if there are so many more people in work. We just have to hope that if there are serious distortions, these will unwind as we move through the year.

The second explanation is that there has been an even larger increase in the cash-in-hand economy than previously estimated. The best estimate I have seen on this comes from a paper by Charles Goodhart for Morgan Stanley, where he suggested that the grey economy might have added 4-5 per cent to gross domestic product (GDP) since 2008. That would explain the strong job growth and strong consumption over the past couple of years but unless you think that there has been a further surge in this grey economy since spring 2013, it is hard to explain quite why income and NIC revenues remain so weak.

The third explanation is that high-earners have become much more adept at running their tax affairs. The top 1 per cent of earners pay nearly 30 per cent of income tax and, as the Institute for Fiscal Studies has warned, it requires only a small shift in their financial planning to undermine the Government’s tax base. The surge in self-employment may be associated with this. Tax push-back would not, however, fully explain the fall in NIC receipts, which does seem a bit odd.

So, it may be that revenues will recover. We are, after all, only two months into the financial year. But there is a lot of ground to be made up and if revenues don’t recover, then we will be pushed to the harsh conclusion that rapid growth is not enough to repair the Government’s finances. This has profound political implications. It will be embarrassing for the coalition and George Osborne for obvious reasons. But it means that the next government, the one elected next May, will have an even larger fiscal mountain to climb than the present one faced when it came to power.

Think of it this way. The deficit the coalition inherited was 11 per cent of GDP. Roughly half of that was cyclical, roughly half structural – you can argue about the precise split but a 50/50 division won’t be that far out. The next government will inherit a deficit of around 6 per cent of GDP, so you could say that half the job has been done – but only half.

The present parliament has mostly been about dealing with the cyclical problem, the legacy of the financial crisis. The next one will be mostly about dealing with the structural deficit, the one we had (but did not fully understand we had) before the crisis hit. I think all three major parties have assumed that as the economy grows, tax revenues will climb enough to enable ourselves to dig our way gradually out of this. But if the present rapid growth is not increasing revenues, the second half of the job will be even harder than the first. Either taxes have to rise further; or there will have to be spending cuts over and above the pretty savage ones already projected; or, given the way the world works, most probably both. Keep your fingers crossed that revenues improve in the months ahead.