Outlook: Brown's golden rule faces testing times as tax revenues dive

Pension chaos; TXU/Powergen

Romano Prodi, President of the European Commission, thinks the euro's growth and stability pact is "stupid" and in need of reform. Gordon Brown wouldn't presume to use such intemperate language about someone else's pact, but he's essentially been saying the same thing ever since he became Chancellor five and a half years ago. Much better, he would say, if the eurozone adopted the Brown proprietary system for controlling the public finances – the "golden rule" as limited by the rule on sustainable borrowing.

The golden rule dictates that it is perfectly reasonable for governments to run mild budget deficits provided that the budget is balanced over the lifetime of the economic cycle. Furthermore, in countries such as Britain where public services are in clear need of investment, it's fine to borrow to invest provided that overall debt doesn't rise to unsustainable levels, defined by Mr Brown as no more than 40 per cent of GDP. The problem with the stability pact rules, he has long argued, is that it makes no such distinction between high and low-debt nations, nor does it allow for the need during economic downturns for governments to borrow their way out of recession.

With the inflexibility of the pact predictably and cruelly exposed by the present downturn, most Europeans are beginning to warm to Mr Brown's ideas, which are largely based on the common sense principles of good housekeeping. What to make, then, of the Ernst & Young Item Club report yesterday, which warns that there is a 50 per cent probability of the Chancellor infringing his own golden rule. Never mind the growth and stability pact, which fortunately we are not bound by, Mr Brown's own flexible friend is in danger of being breached too, says the Item Club.

Mr Brown will no doubt insist that no such breach of the rules is actually taking place when he defends his handling of the public finances in the pre-Budget report next month. The great beauty of the golden rule from his point of view is that you only really know whether it has been breached at the end of the cycle, which can be as long as the Chancellor cares to make it. What's more, with one of the lowest ratios of public debt to GDP in Europe, Britain has scope under its own rules for lots more borrowing for investment purposes before it knocks up against its own self-imposed ceiling.

Even so, it is hard to argue with the Item Club's central thesis. The problem the Chancellor has is that the Treasury produces its own "cyclically adjusted" estimate of the state of the public finances. Even on the Treasury's own forecast for 2002-3, the cyclically adjusted figure is barely in surplus and if the Item Club is right that tax receipts might fall short of forecast by as much as £7bn – only too plausible given what's going on among traditionally big paying parts of the economy like the City and corporate profits – then there is no surplus at all. Hence the Item Club's evaluation that there is a 50 per cent chance of a breach, since the margin of error in forecasting such big numbers is high either way.

OK, so what's a small deficit between friends, even on a cyclically adjusted basis? Not much, maybe, but once the principle of a rule has been breached, then you are on a slippery slope and the rule eventually ends up meaning nothing at all. Up until last year, the Chancellor had a following wind in all he did. That's just changed to a strong headwind. As the Chancellor embarks on some of the biggest increases in public spending ever seen in peace time, the economy is hitting the buffers. Even under his own highly flexible rules for governing the public finances, Mr Brown may be in some difficulty.

The Chancellor is said to be taking some delight in seeing Europe come round to his own way of thinking on budget deficits. If the movement for reform is as real as Mr Prodi seems to suggest, it may even succeed in removing some of the Chancellor's long held doubts about British membership of the euro. But he should perhaps first be looking to the mote in his own eye. Mr Brown faces his first big test – tax more, spend less, or breach his own rule. It's your call Mr Brown.

Pension chaos

Few areas of the tax system are as complex and apparently lacking in reason as the bit that affects pensions – and boy is that saying something. Simplification should be a priority, and indeed there has long been a Government task force looking into the whole issue. The pensions tax system also perversely favours the better off. The lower paid get a smaller tax break. To the Government this seems to be wholly the wrong way round.

Ergo, weekend press reports that the Government is considering abolishing the higher rate 40 per cent tax relief on pension saving and replacing it with a more progressive system that would weight the big tax incentives to the first so many hundreds of pounds of saving. It scarcely needs saying that the consequent decoupling of pensions taxation from income tax would make an already complex system even more so, as well as making more than 2.5 million higher rate tax payers very unhappy indeed. At a time when the Government is already accused of messing up one of the most mature systems of private and occupational pensions in Europe, does it really want to take such a risk?

All the evidence is that tax incentives to encourage people to save more don't work except among the better off who can afford to save anyway. The more radical approach would be to abolish all forms of tax relief on saving for a pension and replace it with a government contribution – say £1 for every £2 saved.

A really radical government would also abolish any form of tax on income from such savings, since it is oppressive to tax income twice. Unfortunately, realpolitik dictates against such free thinking. The Government won't do anything that has the potential to cost it more than the present system. So it will carry on tinkering. Tax simplicity seems as far away as ever.

TXU/Powergen

Powergen managed to shed more heat than light on the real price it paid yesterday for TXU Europe's energy supply business. Suffice it to say that, with the help of the parent company Eon's very deep pockets, Powergen is paying top dollar.

Taking £1.6bn as the value of the deal, Eon is paying £306 per customer, which is almost as much as the French forked out for Seeboard. Ed Wallis, the chief executive of Powergen, calls it a "stonking good deal" even though most analysts reckoned the business was not worth any more than £250 a customer and TXU Europe was a forced seller because of the dire financial health of its US parent company.

Still, Mr Wallis has bought himself and his German masters market leadership in UK electricity supply and that is arguably worth a premium. TXU's 5.3 million customers will increase Powergen's share of the electricity market to 21 per cent. Normally, that is the sort of threshold which makes regulators begin to twitch. But TXU's parlous financial state means Brussels isn't objecting. The UK Government is unlikely to kick up a fuss either if it keeps the lights on and prevents its energy policy from looking even more of a shambles than it already is.

There are now only four UK energy companies that really matter – Powergen, Innogy, London Electricity and Centrica – and only one of those is UK-owned. The Germans and the French have advanced as the Americans retreated. Domestically, Scottish & Southern and ScottishPower are beginning to look like also-rans. They were completely outgunned by Powergen for TXU, leaving SS&E's Ian Marchant to fall back on the old line about the dangers of overpaying. He's probably right, but with the big game hunters still out there, he could yet find himself next in the firing line. The Scots may yet be forced to huddle together for warmth.

jeremy.warner@independent.co.uk