Balancing the books: Repairing the public finances

More than most, and despite turbulent economic times, the 2009 Budget, which will be delivered a week today, seems set to spring very few surprises, if only because the Chancellor has so little room for manoeuvre.

The size of the "black hole", and how the Chancellor plans to fill it, will be the centre of City attention. The Government needs, and wants, to convince the markets that, having shredded its old fiscal rules last year, it does have a credible plan to repair the public finances.

The markets seem happy to buy gilts for now, not least because the Bank of England's programme of "quantitative easing" provides a steady guaranteed demand for them. But that appetite could soon be sated. The question is whether any British government can gain a mandate to put the public finances back into a sustainable equilibrium: can the pain to the electorate that that implies, in tax rises and public spending cuts, be delivered by this, or any future government?

This year's public borrowings are set to rise to £95bn, against a pre-Budget report estimate – made halfway through the fiscal year – of a £77.6bn shortfall. In Alistair Darling's first Budget, this time last year, the Chancellor thought it might be a mere £42.5bn. That is some indication of the sharpness of the downturn, and what it has done to tax revenues, especially from the City and the housing market. Public investment is also running somewhat ahead of plan – by around £4.3bn. Next year, 2009-10, should see public borrowing hit its peak – 11 per cent of GDP, or about £165bn, according to the IMF's latest estimates. That will be the biggest among the G20 nations.

Next year's borrowings will also represent the highest level of borrowing, in relation to the national income, seen in any year since the Second World War, beating previous records set by Denis Healey (1974) and Norman Lamont (1993). It will be more than four times greater than the £38bn forecast in the 2008 Budget, and compares with a forecast of £118bn as recently as the pre-Budget report – a prospective error of 5 per cent of GDP, by far the largest in at least four decades of Treasury forecasting.

Succeeding years will be hardly less challenging; the rough City consensus suggests that something like £550bn will be added to the national debt from 2009-10 to 2011-12. Even that scale of borrowing will leave the UK's total stock of debt some way below some other leading economies: a truly appalling slump would be needed for Britain to catch up with Japan's huge stock of debt, standing at some 193 per cent of GDP. However, adding half a trillion pounds to our existing national debt will take it from less than half GDP to three-quarters, and possibly far beyond that. It was last at those sort of levels in the late 1970s.

Yet even these heroic levels of borrowing are not the issue. It is more that these deficits seem so persistent, as well as large. There is no clear or easy path to tackle them. The Government's own "temporary operating rule", not as precise as the old fiscal rules, has as its aim: "To improve the cyclically adjusted current budget each year, once the economy emerges from the downturn, so it reaches balance, and debt is falling as a proportion of GDP once the global shocks have worked their way through the economy in full".

So how will the Government demonstrate that it has a credible path back to fiscal probity? The Institute for Fiscal Studies (IFS) recently put some numbers on what would be needed to repair the public finances, that is even to get them to balance – borrowing only to invest – by the middle of the next decade.

The IFS says that, extrapolating the Government's own optimistic forecasts, the national debt only declines to Gordon Brown's old target of 40 per cent of GDP sometime in the 2030s; but a more realistic path puts national debt growing steadily to around 90 per cent of GDP by the 2050s, and only then stabilising. That is assuming no change in policy – but long before then the cost of servicing that sort of debt could become painfully high.

Thus the case for adjustments soon. The IFS say that for the Chancellor to do as he has said – taking current spending to balance by 2015-16 – will need an additional fiscal tightening – tax rises or spending cuts – growing to £39bn a year by then. Questions about the public finances now become increasingly political, and capital as well as current expenditure will come under extreme pressure from voters weary of their tax burden.

Even as matters stand, the Government is only budgeting for a 1.1 per cent real increase in public spending from 2011 to 2016. If the whole of the burden of additional reductions in borrowing were to be placed on public spending, then it would mean an overall real terms freeze, with sacrifices in some "front line" services to make way for inevitably higher public debt interest payments and unemployment benefits.

New schools, hospitals and roads could be vulnerable, as they are often the easiest items to postpone; then again they qualify as "borrowing to invest" and may be sustained. "Front line" services are likely to be hit in other ways. Public-sector workers such as nurses and teachers might see little if any improvement in their pay and numbers; generous final-salary public sector pension schemes might be closed to new entrants; pensioners might only see minimal, inflation-linked rises; defence is also another traditional target for Treasury cuts that are "invisible" to the voters.

If, on the other hand, the burden were to be placed only on taxation, it would mean a tax hike equivalent to £1,250 per family. Again, if history is any guide, Whitehall will try to shuffle off as much as possible to local councils, so the council tax looks set to be even more resented than now. VAT will be restored to 17.5 per cent on 1 January 2010, but could be raised still higher. Other increases in personal tax seem inevitable.

As in Ireland's emergency budget last week, the pain will be most intense for Middle England. The new 45p higher rate for those on more than £150,000 may only be the first instalment of a more progressive system. Removing the few remaining middle-class tax perks, such as higher rate tax relief on pension contributions, might raise as much as £5bn.

Chancellors are also fond of leaving thresholds unchanged, hiking national insurance contributions from employees and employers, fiddling with corporate tax reliefs and other "stealth" means of raising the tax take. Reforming inheritance tax will be more difficult now.

Most independent analysts agree that the Chancellor has very little room for manoeuvre indeed. As the Governor of the Bank of England, Mervyn King, recently warned, the scale of public borrowing already scheduled leaves little scope for any additional, "discretionary", boost to the economy along the lines of the £20bn package in November's pre-Budget report. What we are likely to see next week are some headline-grabbing initiatives on "scrappage", more support packages for business and plans for "green jobs". But the tough choices will be left until after the next general election, and for a new chancellor.