Leading Article: On the horns of a fiscal dilemma

IT COULD almost have been billed 'Not The Mansion House Speech'. To begin with, it took place, as it has done for the past couple of years, at Guildhall. Then the date had been changed. Mansion House speeches are conventionally made in October, just before the Autumn Statement on public spending, and are an opportunity for the Chancellor to expatiate on City affairs and the technicalities of monetary policy. Thanks to the new 'unified' November Budget and the requirements of 'purdah', the speech now has to be delivered in mid-summer. With such an erosion of tradition, Kenneth Clarke, the new Chancellor, felt sufficiently liberated to avoid detail with which he has not yet become comfortable and to use the occasion to paint a broad-brush picture of his general economic views.

Unsurprisingly, he sought to depict himself as a doughty battler against inflation, and committed the Government to hitting the lower half of its 1-4 per cent inflation target range by the end of the Parliament. Nothing wrong with that, save that the British economic forecasting fraternity is unusually divided about current inflation prospects. The pessimists see inflation rising well outside the target range next year because of the effects of devaluation. The optimists believe that, on the contrary, inflationary pressures will continue to be subdued for the foreseeable future.

Factors in the optimists' favour are the slow growth of so-called 'broad money' (M4); the under-use of productive capacity measured by the 'output gap' which suggests that GDP is some 4-5 per cent below its trend potential; the very low level of inflation expectations of industry; unit labour costs falling for the first time since 1967; and the relatively healthy state of profit margins (less need to rebuild them as the economy recovers). Given that the Chancellor is almost certainly hoping to avoid any increase in base rates until the economy is growing much more strongly, he has decided unequivocally to put himself on the side of the optimists.

He is probably right to do so, but he might have been a little more cautious. Intriguingly, Mr Clarke indicated that he was not closing the door on the possibility of giving the Bank of England statutory independence. In the circumstances, his own relations with Eddie George, the hawkish new Governor of the Bank, will be closely scrutinised.

Also as expected, Mr Clarke spoke sternly about the need to address the fiscal deficit. As he said: 'No Conservative Chancellor can accept for long the need to borrow pounds 1bn a week to finance the deficit.' Although accepting that the recession did not account for the whole of the deterioration in the public finances, disappointingly he was not prepared to hazard a guess as to the split between the cyclical and structural components of this year's anticipated pounds 50bn PSBR. The answer may well be that nobody in the Treasury really knows. But, at a rough estimate, the rise in personal taxes pre- announced by Norman Lamont in the 1993 Budget, worth about 1.5 per cent of GDP, did half of what was necessary to address the problem. To judge by his words last night, Mr Clarke knows that, come November, he is going to have to take further action.

Whether that action will take the form largely of spending cuts or of tax increases will depend upon how Mr Clarke reads the political tea leaves. The Chancellor is on his mettle to show that he can bring some of his famous toughness to bear on spending departments between now and the autumn. The right of the party has signalled that a retreat on income tax would be the end, and even many less ideological Tory MPs are convinced that to raise income tax would, after the tax-dominated Conservative election campaign, remove whatever tatters of legitimacy still adhere to the Government. Against that, anyone who thinks that Michael Portillo's 'fundamental reappraisal' of the Government's spending and welfare commitments will uncover more gold-mines than land-mines is suffering from the triumph of hope over experience. Mr Portillo's is a well-trampled path and it is improbable that John Major, with a majority of 18, will cut and chop when Margaret Thatcher, with a majority of 140, preferred to leave her sword sheathed.

While it is possible that modifications in company taxation may go some way towards filling the revenue hole, it is inescapable that more will have to be done on the personal tax front. The imposition of VAT on fuel had an unpleasantly regressive feel to it, and there must be limits in equity to a further rise in indirect taxation. The proper conduct of economic policy points to an increase in income tax which could be safely accompanied by a 1 per cent cut in base rates. It would continue the sensible rebalancing of monetary and fiscal policy which Mr Lamont embarked upon after Black Wednesday and would nurture the recovery. It would, however, take a politically confident government to do it - and that we do not have.