Hamish McRae: So you think we live in a two-tier system now? It will get a lot worse

Economic view

It is time to stand back. We do now at last have a Budget date, Wednesday week, and with it we have in effect the start of the election campaign.

We have the prospect of a Conservative-led government though quite possibly without a majority. We do not know the terms on which the Liberal Democrats would support an emergency Budget in June, but we do know the financial markets, rightly or wrongly, have become alarmed about the next government's lacking the political strength to correct the deficit on an acceptable time-scale. Finally, as I argued last week, there is the possibility of a third Budget in the autumn, perhaps after another election.

Whatever the outcome of this political process, the fact remains that the UK will have to correct all or most of its structural deficit within the next five years, by which time we will have a public debt to GDP ratio of close to 100 per cent, more than double the level of 1997 and of course far above the 40 per cent ceiling set by Gordon Brown when he was Chancellor. To put that in an international context, we will have gone from having a relatively low level of public debt, compared with other G7 countries, to having a relatively high one.

To say all this is not to castigate the Government, though I do think history will be harsh on the Prime Minister. Rather, it is to raise the central point that neither main party has confronted: that no government for a generation has managed to increase the tax take beyond 38 per cent of GDP. Yet governments want to spend, or at least they judge that electorates want them to spend, somewhere above 40 per cent of GDP. Some future government will have to resolve this. It has to acknowledge that the UK will, in all probability, soon have a shrinking workforce, and it will certainly have a growing number of retirees as the baby-boomers hit retirement age.

You can see the dilemma in the graph, taken from two charts in the most recent pre-Budget report. It is not quite as bad as it looks, for total government revenues are a couple of percentage points higher than tax revenues, as the Government has other income in the form of rents and so on. As a result, it did briefly get into surplus in the late 1980s and late 1990s. But the central point, that it does not seem possible to get tax revenues above 38 per cent of GDP, stands. At the moment we are struggling to hold tax revenues a little below 34 per cent of GDP and, under present plans, taxes will only go up to just over 35 per cent through to 2014.

As for spending, it is true that under the early years of Gordon Brown, it came down to below 40 per cent. But that was the result of a fierce squeeze that I think now most people recognise was a mistake, as neglect of investment in infrastructure, for example, increased costs later on. Looking ahead, demands continue to mount. Unfortunately, quite aside from the growing needs of the elderly, there will also be that growing pile of debt to be serviced. So we lose another couple of percentage points available for spending on real services.

So what is to be done? The good news is that people are starting to think about it. There are things that can be done on the tax side to make the present revenues more sustainable and less distorting: there has been a paper from the think-tank Reform on this. There is certainly a case for trying to simplify the tax and, particularly, the benefits system. But if you accept that 38 per cent of GDP is the effective ceiling of revenues, then that is the pot that there is to spend.

If you accept this, then you have to question the whole structure of the public sector. Goods and services that could be supplied by the marketplace have already been shed in the great wave of privatisations, starting in the late 1970s: oil companies, airlines, telecoms, motor manufacturers, power utilities and, more controversially, railways. But these were goods and services that people pay for. They are not funded in the main by the tax system. People expect to have free schools, but they never expected free flights or free phone calls.

The core problem now is that we as a society want to spend a greater proportion of our income on services that are, to a greater or lesser extent, provided by the state: health care, welfare for the elderly and education. But we are not prepared to provide the finances in the form of taxation to fund this. That leads to two conclusions. One is that we have to improve the efficiency of the public sector; the other is that we have to get people in some way or other to pay more of their own (ie, taxed) income to buy these other services, either from the state or elsewhere.

On the first, there are some helpful thoughts in a new paper by the think-tank Policy Exchange, "The Renewal of Government". Its author, Neil O'Brien, director of the unit, is critical of public-sector performance in recent years:

"Public-sector productivity fell nearly 4 per cent in the decade after 1997, while in the private sector, over the same period, it grew nearly 23 per cent," he writes. "Despite this, pay has risen by 15 per cent more than in the private sector. The simple truth is that we now need public services run on 21st-century principles – not the rules of the Seventies."

Many of us would agree. Indeed the Government has now changed its approach radically away from the previous emphasis on arbitrary targets and is seeking to improve productivity. It is also trying to hold down pay, at least at the top end, as we were told last week. Present spending plans, which are actually already tight, do assume improved productivity gains.

The Civil Service is now preparing new radical plans for further cuts and it will be the task of the next government to put them in place but it would, I think, be naive to think that improving productivity will solve the problem. We have somehow to get more money into these services.

Again, a start has been made by the Government. University top-up fees are perhaps the best example of getting people to pay for a service they previously got for free and there is no evidence that numbers of applicants have fallen. But I think we will have go further down this path. The result will be distasteful to many. The idea might seem fine – that there is a core service funded by general taxation but if people want to get any extras they will have pay for them. But when you look as to how this might work in practice, things get tricky. I suppose we have it in pensions, for the core state pension is indeed an economy service, but in schools or health care it will be difficult – many would say objectionable – to create more of a two-tier system than there already is. Not easy – but we have to have an honest debate and, after that, take some tough decisions. Not easy at all.

Dyson's report seeks to boost the UK's creativity, but let's not be hasty

Sir James Dyson, he of vacuum-cleaner fame, produced a report last week about how a new government might reawaken the country's inventiveness and creativity. It was prepared at the request of David Cameron but Sir James points out that not all the opinions will be echoed by the Conservatives. The result is more a piece of reportage, because a large number of the UK's scientists and industrialists have contributed ideas.

There are some dispiriting facts: 4 per cent of teenage girls want to be engineers, 14 per cent scientists – and 32 per cent models. Or, patents filed in 2007 in Japan were 330,000, in the US 240,000 – and in the UK, 17,000. More encouraging ones are the number of Nobel Prize winners, and, not in the report, that the UK is the second-largest net exporter of intellectual property after the US.

The report is divided into five sections. First, Sir James looks at culture and what might be done to lift the status of science and engineering; second, at education; third, the relationship between universities and companies; fourth, how to improve financing for hi-tech start-ups; and finally, how to boost R&D.

Ideas range from encouraging internships of students in firms to reforming university funding. It seems to me that some of the most convincing suggestions are those that take existing institutions and make small changes to make them more effective; changes that might be made at regional development agencies, say, and tax changes to boost the flow of funds from business angels. My main reservation is the implicit belief that an incoming government can make such a difference by initiatives. We have had such hyperactivity by the present one that the very expression "government initiative" has taken on a pejorative tinge. (Just think of all the names the poor old Department of Trade and Industry has had foisted on it.)

So yes, let's support science and engineering, and yes, let's appreciate the role in economic development. But first, do no harm; then let's tweak what we have; and then let's do pilot studies to find what really helps.