How much will Labour tax you?

Gordon Brown is playing it close to his chest when it comes to his plans should he become Chancellor. Hamish McRae weighs up the options on taxation, spending and borrowing that he would be most likely to consider

Stand back from the squabbles between the leadership and the rank and file over the detail of Labour's economic platform. Stand back, too, from the inevitable ambiguities that remain over tax and spending policies, for as Gordon Brown, the Shadow Chancellor, made clear yesterday, clarification will presumably not come until the campaign itself.

To understand what a Labour government might do to your taxes, start instead with three seismic shifts in economics since Labour last held power in 1979.

First, the dominance of the market system. Then, as the World Bank recently noted, about 40 per cent of the world's population lived in a functioning market economy; now the proportion is something like 90 per cent.

Second, the transformation in global inflation. There were two peaks of inflation, in 1975-76 and in the early Eighties. Before those, the long-term trend was up; since then it has been down. Government no longer has a choice about how much inflation might be acceptable; any rise is immediately "punished" by a rise in long-term interest rates.

Third, within the developed world there is increasing scepticism about the effectiveness of public spending as a means of achieving social aims. In most countries, this has yet to be reflected in a decline in public spending as a proportion of GDP, but in some (the Netherlands, Belgium, Ireland, New Zealand as well as the UK) there is a clear downward trend. In the UK, this trend was started by the last Labour chancellor, Denis Healey.

In this context, Labour is clearest about its attitude towards public spending and borrowing. Gordon Brown has committed a future Labour government to two rules. The first, which he calls the "golden rule" of borrowing, is that it will only borrow for investment, not for consumption. The second is that the ratio of public debt will be stable and kept "at a prudent and sensible level".

The first rule is open to wide interpretation, for "investment" is a word frequently used to cover what is in any accounting sense current spending, for example, investment in education. But the second, if adhered to, should contain any rise in borrowing to the rate of growth of the economy as a whole: this would suggest a budget deficit averaging about 2.5 per cent of GDP, well within the Maastricht ceiling of 3 per cent and substantially lower than the deficit over the life of the present Parliament.

Yet this fiscal prudence does not tell us much about the size of the public sector under Labour. For that we need to look at taxation. The most important institutional change would be the introduction of a Green Budget, for discussion of tax changes, several months before the Budget itself.

Mr Brown has suggested an income tax system that will reduce the tax burden on the low-paid and middle-income earners but will almost certainly increase tax rates of the higher earners. His suggestion (as a long-term objective) is that income tax will start at a lower band of 10 per cent,instead of the present 20 per cent, and move upwards in steps. The present top rate of 40 per cent will presumably be increased, but what that rate will be and the level of income at which it starts have not been disclosed.

Last week's spat over Clare Short's remarks that someone at her income level should be prepared to pay more tax suggests that any higher rate over and above the 40 per cent band would not start until an income of perhaps pounds 40,000. But even that level would catch a lot of people. John Prescott has admitted that many would pay more tax under Labour.

Some further clarification here comes from Tony Blair. He has made two important statements on tax. One is that Britain's top tax rates will be internationally competitive. The other is that he recognises that many professionals - for example, in the financial services business - are mobile; securing these activities in the UK requires appropriate taxation. It is not at all clear what "being competitive" means. If it means being competitive by European standards, it would suggest an increase in the top rate to perhaps 50 per cent. If it means being competitive with East Asia and the United States, it would leave very little scope for a tax rise at all, which seems unlikely.

A clever policy might be to hold the rise in top rates below 50 per cent, say to 45 per cent. That would be below that of the large European Union countries and, allowing for state and local taxes, not much higher than the United States.

But income tax isn't the only personal tax that is likely to rise. Gordon Brown has strongly attacked Conservative aims to abolish both capital gains tax and inheritance tax. The rules on both may be tightened. Yet there will also be tax incentives that may benefit the well off. Mr Brown has committed a Labour government to further incentives for saving. Present PEPs and Tessas seem likely to be maintained, and probably supplemented by some kind of individual savings account, which would be encouraged by tax concessions, paid after a qualifying period.

On indirect taxation, there are few clues. Mr Brown says that he would like to see a cut in VAT on fuel, but that would presumably apply only to fuel used in the home. It would be consistent with the tone of his approach for there to be higher taxation on any polluting activities, including road transport. Increasing VAT seems unlikely.

On company taxation, less is known, though the forthcoming corporate tax review will clarify things. One of the few specific suggestions is a windfall tax on the profits of public utilities, and Brown has criticised the use of offshore companies to escape taxation. There are words of encouragement for small and medium-sized businesses as creators of jobs, so it is unlikely that taxes on them will rise.

So where do these calculations on tax and borrowing leave us on public spending? In practice, the level of spending will be limited by the available revenues. If the taxation principles above are adhered to, they will create little additional revenue. There will be few bonuses from further privatisation as that cupboard is bare. Add in that fact and it is quite possible that a Labour government which intends to stick to its principles would have to tighten fiscal policy: public spending in future might be lower than it is now, however surprising a conclusion that may seem. Two things are likely to happen to public spending: it is likely to be redirected towards low-income families, and there will be a drive for better value for money.

Further, there will be a drive for better value for money in public spending. Mr Blair has praised a speech by Sir Geoffrey Holland, former permanent secretary at the Department of Education, now Vice-Chancellor at Exeter University, who argued that there could be a 30 per cent improvement in the education system within existing budgets.

Expect more of the same on interest rates, although Labour has pledged to give the Bank of England more independence, while making the way it sets monetary policy more open and accountable. The solidity of Labour's commitment to a single currency is not clear, but, in practice, policy seems slightly less hostile than that of the present government.

Criticism of Labour's economic platform from the right has generally followed a predictable line: new Labour is really old Labour with a more agreeable face, that when push comes to shove it will be a tax and spend, anti-business government. Behind this is the idea that Tony Blair and Gordon Brown will not be able to keep full control of economic policy, and the old, and still very evident, instincts of the rest of the party will dominate. This is a legitimate concern. Tony Blair adopts a completely different tone - particularly when he is speaking abroad - from those of his colleagues, including members of the Shadow Cabinet. It is almost as though they see two different worlds.

My own view, though, is not to be too concerned about this, not just because of the Blair/Brown dominance of the party, but more because the practical reality is that there is no alternative to the model now accepted by the leadership. Any straying from fiscal and monetary orthodoxy will be punished with swift ferocity. A Labour government will be given less benefit of the doubt than a Tory one. This is perhaps unfair but inevitable because of the legacy of distrust in the business and financial community.

My greater concern is that expectations of what a Labour government might achieve in economic policy run far beyond any conceivable reality. Gordon Brown's belief that changing economic polices will lead to higher growth is, at best, extremely optimistic. Tony Blair's belief that improved education will lead to greater prosperity has long-term merit, but it could take 10 or 20 years.

So much of the political debate in Britain presumes that the economic policies we adopt here are of great importance. Viewed from outside, they are not. It is a typical medium-sized economy with some strengths and some weaknesses. The UK is part of what inevitably will be a slow-growth zone in Europe, but it benefits from being one of the most outward-looking of the European economies. It can be nudged helpfully by appropriate government action, but all one can really ask for is reasonable competence.

That we may get from Tony Blair and Gordon Brown. But if we expect anything more, I fear we will be gravely disappointed.

Brown's Budget plans at a glance

New income tax higher rate: 45 per cent

Payable on income over pounds 40,000 Government borrowing to be cut to average 2.5 per cent of GDP

Interest rate policy unchanged Incentives for long-term saving VAT unchanged but cut for domestic fuel

Corporate tax under review Public spending virtually unchanged