News Analysis: 'Iron Chancellor' risks losing his reputation for fiscal prudence

Gordon Brown faces his most severe test as Chancellor today as he struggles to maintain ambitious and politically crucial spending targets with the economy in the grip of a global downturn.

Weakening growth, falling tax revenues and the prospect of large increases in borrowing threaten to damage Mr Brown's jealously guarded reputation for caution as he maintains the investment in public services on which Labour has staked its future. Opposition parties will accuse Mr Brown of casting aside economic prudence, characterising him as a Chancellor whose luck has run out and with no voter-friendly reforms to pull out of his red dispatch box.

BORROWING

For the first time in his five years as Chancellor, Mr Brown will have to explain away a ballooning deficit rather than being able to celebrate another unexpected surplus for the public finances.

Mr Brown had already planned to let the UK plunge into the red to pay for his huge investment plans but today's numbers will be much more grisly than the figures that appeared in the April Budget.

Back then he forecast a shortfall of £11bn this year and £13bn in 2003-04 followed by deficits of £13bn and £17bn. Today Mr Brown is expected to admit that the shortfalls for this year and next will be about £16bn and £20bn respectively.

The scale of the economic slowdown means that the Treasury must borrow up to £12bn more than he expected to keep his spending plans on track. Some economists in the City are even more gloomy, warning of shortfalls of as much as £40bn over the next four years.

The Treasury's analysis of independent forecasts is also gloomy, showing borrowing that is predicted to be £15.5bn this year and £19.5bn next.

The Chancellor will be able to blame the global slowdown for dragging down growth in the UK. He can say that this in turn has reduced tax revenues as receipts from corporation and income tax have suffered. But he will insist that this is just a temporary problem that will unwind when the economy rebounds. Is this prudent though?

Some economists, such as the team at HSBC, believe that there is a more deep-seated problem, arguing that much of the huge surpluses of the late 1990s were linked to a stock market bubble that may not return for a decade.

In the short term, the Chancellor has a clear choice: let borrowing run up even higher, cut spending, or raise taxes. He will insist that the country can afford to live with a larger deficit. This may be a safe bet for now but many experts believe that unless the economy enjoys a remarkable boom, he may have to hike taxes to still a "black hole'' that will emerge the other side of a general election.

GROWTH

One of the biggest surprises from April's Budget was the Chancellor's bold decision to raise his forecasts for UK economic growth in the face of the worst global shock for more than a quarter of a century.

Today he will have to eat humble pie. This year the economy will probably grow by just 1.6 per cent compared with his bullish prediction of 2 to 2.5 per cent. The provision for next year will be even more dramatic. Hoped-for growth of 3 to 3.5 per cent will vanish and could be replaced by a figure as low as 2.25 per cent.

An analysis of City forecasts compiled by the Treasury puts growth at 1.6 per cent this year and 2.5 per cent next year. The lowest forecasts surveyed put growth next year as low as minus 0.3 per cent.

Mr Brown will be under pressure to justify his decision in April to raise his estimate for the long-term trend of growth, which allowed him to conjure up an extra £6bn of tax revenues over the next four years. He will probably resort to the recent cut in the estimate of the British population, which will allow him to say that productivity growth has been much higher than previously thought.

Britain has emerged with the fastest growth of any of the Group of Seven nations – Canada, France, Germany, Italy, Japan and the United States.

But beneath the surface the picture is not so pretty. The economy is being supported solely by consumer spending and homebuying. So while Mr Brown can raise his forecasts for householders' spending, he will have to cut yet further predictions for the UK's beleaguered manufacturing sector.

The short-term outlook might not look that bad, but in the long run there will be a heavy reckoning unless the Government can engineer an end to this severe imbalance.

PUBLIC SPENDING

Massive increases in spending on public services underpin the Government's drive to improve schools and hospitals, and provide the foundations for Labour's hopes for an historic third term in power.

Gordon Brown plans to increase spending from £418.4bn this year to £511.4bn by 2005-06. Under plans outlined in Mr Brown's three-year review, departmental spending will rise from £239.7bn to £301bn; a rise of 3.3 per cent in real terms in both 2004-05 and 2005-06.

Sixty-four per cent of the spending by government departments and local authorities will fund the politically-crucial areas of education and health.

Questions hang over the Government's ability to fund its spending package in the last years of this Parliament, questions which can only be exacerbated by the downturn.

Research by the National Institute of Economic and Social Research warned that the Government will have to raise taxes by £15bn over the next five years to fill a "black hole" in its spending plans and keep the public finances in balance.

But on Monday, Mr Brown insisted that the current economic downturn would not deflect ministers from their spending plans. He rejected cuts in spending and borrowing, declaring that "just as we will resist short-term pressures and hold firm in our demand for discipline in pay in the private and public sector, so too we will resist pressure for the old short-term quick fixes in fiscal policy".

TAXATION

So will the Chancellor be forced to hike taxes? His biggest headache is the dramatic collapse in taxation revenue.

The most recent figure, for October, showed that the Inland Revenue raised about 13 per cent less than it did a year earlier. The main culprit was corporation tax, which is down by 27 per cent year-on-year.

Total government revenues so far this year are up just one per cent on a year ago, compared with a Budget forecast of 4.2 per cent for the full 12-month period that ends in March. With government spending accelerating even faster than it had expected, the result – as Charles Dickens' Mr Micawber would have said – is misery.

However, City economists are unanimous that the Chancellor will not need to increase taxes to fill that hole – at least for now.

With the economy in its worst state for a decade, business profitability declining and the consumer single-handedly keeping the economy going, the UK needs a tax hike like a hole in the head.

The Treasury has already ordered a one percentage point rise in national insurance contributions for employees and employers that will bite in April.

In fact, Mr Brown has hinted he might abolish the archaic system of royalty payments by North Sea oil firms. He may also offer some help for companies that have seen their insurance costs rise recently by as much as 300 per cent.

But there are fears he may try to push through some hidden tax rises to pay for this.