Hamish McRae: Even after the latest tinkering, Brown may break his golden rule

Gordon Brown hit the headlines this week with his sudden discovery that the current economic cycle began in 1997 and not 1999 - a revelation that may allow him to stay within his "golden rule" on borrowing next year without having to increase taxes. But, as has been widely recognised, his golden rules are pretty arbitrary and redefining the economic cycle does not change the underlying fiscal numbers. There is actually quite a lot of sense in the idea that the cycle started in 1997 rather than 1999 because it must be right to ignore mini-blips. Actually I would have said that the last economic cycle started in 1991 or 1992, because that was when the long boom started and that it ended in 2000 or 2001 with the global downturn. Then a new cycle got under way and it will duly end in - who knows - maybe 2007? But I suppose politically Mr Brown cannot say that because to do so would acknowledge that he inherited a strongly growing economy.

But all this focus on the cyclical position diverts attention from the much more important matter of the structural position. We got new figures on that yesterday and the news ain't great.

We are just three months into the new financial year and borrowing is running well above last year, even though it is supposed to turn out less - as you can see in the first chart. Receipts are a little up on last year (second chart) but not much. Meanwhile spending has carried on at the higher level (third one).

The basic message is that in the first three months of the financial year the Government has already borrowed (on public sector net cash requirement or PSNCR basis) £16.4bn, nearly half the £34.8bn he is supposed to borrowing for the full year. You cannot extrapolate that and say that he, or rather we, will end up £65bn down the slot. Taxes are paid in lumps, with July and January being the two biggest months for revenue. What you can say is that the City analysts are pencilling in figures closer to £40bn, some more, for the year as a whole.

What should we make of all this? It is not sensible to be fazed by one set of numbers. Let's assume, just for the sake of argument, that borrowing this year does indeed turn out to be £40bn. That would be equivalent to about 3 per cent of GDP, maybe a bit more. But it would probably turn out to be lower than the corresponding deficits of France, Germany or the US.

So the worry is not for now. Rather it is that the trend in revenues will deteriorate further in the months and years ahead. For four years tax revenues here have come in below the numbers the Treasury expected and the gap has been filled by unplanned borrowing. But this undershooting happened when the economy was growing strongly. Now growth is faltering, not just here but on the Continent too. (The US still canters on, as Alan Greenspan's testimony yesterday confirmed.) As far as the UK is concerned, I don't think we should rule out the possibility of there being a quarter when the economy actually shrinks: when there is in the jargon, negative growth. To be clear: this is not a probability, but it is a possibility.

The Bank of England minutes yesterday underlined this new fragility. Things have damped down much more swiftly than was evident even two months ago and it does now look odds-on that the first cut in interest rates will come in August, with further cuts before Christmas.

The primary question then will be whether these cuts will revive the economy. Will people say: "Wow, let's go and buy a new washing machine."? Or will they say: "Phew, now we can pay down that credit card debt a bit faster."? Probably a bit of both - ie they will help the economy a bit but not as much as the authorities will hope.

The subsidiary question is whether these cuts will rescue the public finances. Here the answer will probably be much the same. The Government gets is revenues in two main ways: taxes on spending (which it oddly calls taxes on production) and taxes on income. You can see the monthly revenue figures on the ONS website if you are interested.

The spending taxes track what is happening to demand pretty closely, as you would expect. The largest single revenue raiser here is VAT, and there are also excise duties and the like. So if we spend money on more or less anything other than food and public transport we give the Government money. As the economy has slowed so too has the growth in revenues. They don't look bad, just a bit flat. The danger of course is that they may become flatter.

The other big wodge of revenue comes from income tax and national insurance, with a bit more from stamp duty, capital gains tax and corporation tax. NICs grow with employment and pay. Pay has continued to rise by about 4 per cent a year but private sector employment is falling.

Income tax revenues do bounce around. Last year was good, after little growth from 2000/1 to 2003/4. The monthly run so far this financial year is a bit above last year but not a lot. We will learn more in the current month, for July is always the second best month for income tax revenues after January. But if these come in soft, then the Government does have a problem, for the others - corporation tax and the like - just aren't growing: these will little higher last year than they were in 1999/00.

Pull all this together and also what are these figures trying to tell us? I suggest that while revenues are a bit soft, the situation is not as serious yet as you might expect. Given the fact that the economy will be pushed to grow at 2 per cent this year instead of the 3-3.5 per cent announced by the Chancellor in his pre-election Budget, you would expect taxes to fall short of plans. They are, but not terribly so.

But the word "yet" is the operative one. If the economy does not pick up after the interest rate cuts, or if it takes a while to do so, then government revenues could become very soft indeed. We will be all right this year but next could become really difficult, notwithstanding this rewriting of the fiscal rules. The Treasury is postponing the review of its longer-term spending plans - the other announcement this week.

This has been spun in political terms as a change of plan to chime in with the orderly transfer of power from Tony Blair to Gordon Brown. But there is also an economic element here. It is also prudent, given the way tax revenues are falling short of plans, not to promise to spend more until it is clear you have the money to do so. Sure you can put up tax rates but then you clobber growth, as Germany has discovered, and you may not even get in any additional revenue.

It is too early to panic, but the fact that the Government has had to borrow nearly half its stated annual allocation in the first three months of the fiscal year is not good news for anyone.