Economic Commentary: Cure for government tax headache

Both the Prime Minister and Chancellor showed a worrying tendency last week to hark back to the 'successes' of the 1980s. First Norman Lamont, in an uncharacteristically polemic moment, announced that it was a 'self-denigrating myth' to say that British manufacturing was in decline, and added that he was not particularly worried about the balance of payments deficit. Then John Major opined that Britain was about to embark on the same kind of 'sustainable' upswing that it had enjoyed in the 1980s.

The tone of these remarks was uncomfortably redolent of the middle period of the Lawson chancellorship, when dangerous self-satisfaction was abroad. This is excusable fare for ministerial new year messages, but if too much rosiness seeps into the serious business of policy making in 1993, trouble will inevitably follow.

The whole point about the economic growth recorded in the 1980s was that it was not sustainable. It was generated by an unsustainable increase in consumption; it rested on an unsustainable explosion of debt; and it was financed by an unsustainable run-down of our oil assets. Unsustainable was the middle name of the 1980s.

All this is relevant to the question dominating Treasury thinking at the moment, which is how much, if at all, taxes need to rise in the next couple of years. If the economy can embark on the kind of recovery it recorded in the 1980s, then the Prime Minister is right to suggest that much of the present high level of borrowing will simply melt away, and that there will be relatively little need for tax increases before the next election. On the other hand, if the economy cannot replicate the growth of the 1980s, because of the exceptionally weak starting position for the balance of payments, then the PSBR will remain a problem, and tax increases will probably be necessary.

CRUCIAL QUESTION

It is, admittedly, very difficult to be sure how much taxes may need to rise. But consider the following arithmetic. Next year, depending on the growth rate in GDP, and the rate at which plant and machinery are scrapped, the economy might be working somewhere between 3 per cent and 6 per cent below 'full capacity'. Let us take the centre of this range and say that output will be 4.5 per cent below capacity. Meanwhile, the PSBR, excluding privatisation, may be about 9 per cent of GDP (or just over pounds 55bn).

The crucial question is how much of this government borrowing is due to the automatic effects of the recession on tax and public spending, and how much is 'structural', implying that it will remain in place after the recession is over. It is the latter that the Chancellor should seek to reduce over the medium term.

One way of estimating how much borrowing is structural is simply to ask what the PSBR would be next year if the level of output were increased by 4.5 per cent, thus magically restoring the economy to full capacity working. According to rough calculations by the Institute for Fiscal Studies, the PSBR would still be as high as 6 per cent of GDP on this assumption. But an acceptable medium- term target for the structural budget deficit would be no higher than 2 per cent of GDP. Therefore a budgetary tightening equivalent to about 4 per cent of GDP ( pounds 25bn) is needed.

Fortunately, some of this is likely to come from a decline in the share of public spending in GDP as the economy recovers. If the Chancellor is able to stick to his most recent targets for public spending (admittedly, rather a large 'if'), about half of the required budgetary tightening could come this way. This still leaves the other half - roughly pounds 12bn - to be found from tax increases.

This is indeed a daunting figure for a government that has somehow managed to persuade the electorate (quite contrary to the experience of the previous 13 years) that it can deliver continuous tax reductions. It may conceivably be so daunting that the Government will prefer to trust to luck, hoping either that the deficit can be financed, or that the arithmetic outlined above is wrong.

This in fact is what the Prime Minister seemed to be suggesting yesterday, when he claimed that only about one-third of the deficit was structural, and hinted that any need to raise taxes may therefore not be very large. Mr Major must implicitly be assuming that the economy is working at least 6 per cent to 7 per cent below capacity, and that we will be able to eliminate this without encountering severe balance of payments problems over the medium term.

Both of these assumptions are optimistic. In particular, the first is based on the belief that there has been no erosion of plant capacity during the recession, which seems a very rosy view to take (though it is admittedly a view that has recently been shared by the OECD). On what I would consider the more central view outlined above, which is that there has been some erosion of plant and machinery during the recession, spare capacity might now be about 3 per cent to 6 per cent. There would then be less scope for recovery in GDP, and the structural deficit in the government accounts would be correspondingly larger.

POLITICAL FLAK

Such are the huge uncertainties of medium-term fiscal arithmetic that the Prime Minister's relative optimism might well turn out to be justified, and no politician is ever eager to raise taxes on an uncertain prospectus from economic forecasters. But it was because they always made optimistic assumptions that countries such as Italy and even the United States have slid into severe debt in the last decade. Britain is a possible candidate to do the same in the 1990s unless the problem is addressed.

Hence the headache for the Government. If tax increases are announced this year, they could conceivably turn out to be unnecessary, in which case a great deal of political flak would be taken for no good reason. If alternatively the tax issue is ducked, but my less optimistic arithmetic proves right, then the Government could run into a severe financial crisis in the run-up to the election.

There is, however, a way out. What the Chancellor should do this year (probably in December rather than March) is announce staged reforms to the tax system which will raise revenue and which he would quite like to do anyway. These might include a widening of the VAT base, increases in employees' national insurance contributions, 'environmental' taxes such as higher petrol duties, and a phasing out of mortgage tax relief. Such changes could be accompanied by further cuts in base rates designed to keep sterling competitive, and to prevent the balance of payments from becoming too much of a problem during the recovery.

Monetary and fiscal policy would therefore be 're-balanced' in a way that seems appropriate, and the Chancellor would give himself a nest-egg of extra tax revenue building up to about pounds 10bn to pounds 12bn over two or three years, all of it pre-announced. If this should be required to control the PSBR, then so be it.

And if not? Then some of the revenue can be given back in a pre-election income tax cut, and a useful tax reform would have been implemented. A bold plan, perhaps, but surely much better than sitting back and hoping for the best.