Hamish McRae: Governments may have to relinquish fiscal powers as deficits creep up

Blair survives, pound soars, stability triumphs. Buoyed by the excitement at the other end of town, the City markets pushed sterling up against the euro to a two-month high. The markets, it was argued would now stop fretting about political instability and focus on the rapid growth of the economy and the prospect of higher interest rates, which would be good for sterling if bad for home buyers.

So all is hunky-dory? Well, yes and no. Yes, in the sense that in relative terms the UK remains a reasonable prospect for investment and that world growth this year will almost certainly be better than last. But no in the sense that this Government, like those of most other developed countries, is likely to disappoint its electorate in the medium term.

You can see that in the difficulty the Government had in getting through an inadequate funding proposal for university education and the growing evidence of a deteriorating fiscal outlook not just here but also in virtually all developed countries. You can see this week that the Government is bound to disappoint university students (because they have to pay higher taxes) and the universities (because they will still be educating undergraduates at a loss). What is not so immediately obvious is that they will also disappoint taxpayers in general - because funding higher education will remain a burden on a shrinking tax base.

There was no new evidence in the past few days of any further slippage of the Government's finances, though the monthly running total of public borrowing suggests that it is running at about its revised target of £37bn. There was, however, new evidence from America in the form of a report from the Congressional Budget Office. This revised upwards the cumulative budget deficit to 2013 by $1,000bn - and actually was far too optimistic in its assumptions. Private sector estimates suggest that on present policies the deficit will stick at between 3 and 4 per cent of GDP for the rest of the decade.

Europe's position is arguably worse, for the US has a lower ratio of older people and the prospect of higher immigration and hence a growing workforce. The US can grow its way out of trouble in a way that most of Continental Europe and Japan cannot. It starts from a better position too. You should not take any one year's fiscal deficit as definitive but it is worth noting (top graph) that the US and UK fiscal deficits in the current fiscal year are lower than those of Japan, France and Germany.

But what about the long-term question as to fiscal sustainability? The central issue is the extent to which one generation subsidises another. Several European countries, including the UK, have started to plan ahead for a world with a smaller workforce and a larger number of pensioners. But others, most notably France and Germany, have largely failed to do so. Remarkably there seem to be only two countries that have carried out formal studies at an official level, Australia and the UK. Here the Treasury publishes each autumn a statement on the long-term position as part of its pre-Budget Report. The conclusion of last month's one, oversimplifying rather, is that long-term liabilities can be met by a modest rise in the tax burden of a couple of percentage points to just over 40 per cent.

That is reasonably comforting, though I would worry about its assumption on the acceptable level of pensions. By tying our state pension to prices rather than wages, our pensions may simply be too low for society to accept - despite the tweaking upwards of pensions for the most needy under the present Chancellor's plans.

Other countries' positions are far worse. An OECD study in 2001 projected that health and pensions provisions for the over-65s would account for 10 per cent of UK GDP in 2050, but some 25 per cent of the GDP of France and Germany.

You could shave this back a bit by cutting pension rights (as Germany is doing), by getting people to work longer, by trying to increase the proportion of people of working age in some sort of job and so on. But even if you do all this, there will still be considerable pressure to increase taxation. Can it be done?

The blunt answer is probably not. If you ask people whether they are prepared to pay higher taxes in exchange for better public services, in Britain at least they tend to say yes. People also point to the fact that tax in several Continental European countries is higher than in the UK. But the actual proposition is different: it is to pay higher taxes for the same level of services, perhaps slightly worse ones. Besides, if you look at what people do, rather than what they say, the message is that there is a top limit to the tax take. The bottom graph comes from some statistics in a fascinating study of the long-term fiscal challenge facing governments Who will Pay?, by Peter S Heller, a senior staff member of the International Monetary Fund.

The first column of bars shows tax as a percentage of GDP taken in different countries - the UK is a bit lower than now, but these were 1999 figures before Gordon Brown got into his big spending mode. As you can see, Sweden tops the poll. But the higher the tax the higher the shadow economy - the cash-in-hand, tax-avoiding part. The second set of bars show an estimate for that in the late 1990s by two IMF economists, published in an IMF staff paper in 2000. On the graph Belgium and Sweden top the league at 22/23 per cent, though Italy and Greece are even higher. The UK is at 13 per cent and the lower-taxed US at 9 per cent.

Now put the two together. If you allow for the part of the economy that is outside the tax net altogether, the ratio of tax to GDP is much lower (the third bar). In the case of Sweden it falls from 52 per cent to 42 per cent. In every other country the tax burden falls below 40 per cent.

In very round terms, taxes have risen over the past 30 years by almost as much as the shadow economy has cut the tax take. In other words, governments have put up tax rates but people have responded by moving outside the tax system so that the total tax take has hardly risen and in some cases fallen.

Thus in Britain in 1970 our tax take was 30 per cent of GDP, but since the shadow economy was only 2 per cent of GDP, the actual proportion of GDP going in tax is lower now than then.

So governments cannot increase taxation as a share of GDP - or rather only in exceptional periods such as war. If they try and do so, all they do is push activity into the shadow economy. How then are they going to service the debts that they are now accumulating each year?

My guess is that eventually fiscal policy will have to be taken out of the hands of government, just as monetary policy has been given to independent central banks. It will be resisted, of course, but democracies have a way of adjusting to economic necessity. Just as irresponsible monetary policy led to a surge in inflation, so irresponsible fiscal policy is leading to debts that will be very hard to pay off. I would expect some sizeable developed countries to either default on their debts or have some severe fiscal reconstruction.

Not a lot of fun - but the university fees row this week gives a sniff of pressure to come.