Brown's fatal flaw in taxes

THE FAILURE to distinguish between taxes paid out of savings and those which directly hit consumption looks like the fatal flaw in Gordon Brown's first two Budgets. The near-term consequence has been sterling strength, hitting exports. Longer-term effects will be slower growth, deeper recessions and failure to meet the Government's budget targets.

The Chancellor seems rather mystified by it all. Questioned on Tuesday by the House of Commons Treasury Committee, he seemed to think that the management of the economy was not really his business. He thinks the budget deficit is now simply a matter of operating the "golden rule" on borrowing, and as interest rates are the business of the Bank of England, he is left free to tinker with tax and benefits.

Chancellors, however, are judged by their management of the economy. By abolishing ACT in his first Budget, Mr Brown raised taxes on saving when the economy was overheating. Economies only overheat when savings are inadequate, so a tax on savings was exactly the wrong medicine. His mistake was clear and showed up in sterling, domestic demand and money supply rising too much. But he did not learn, and the March budget failed to correct the mistakes.

By abolishing ACT, the Chancellor has raised the explosive power of a time-bomb ticking in the British economy. As UK stocks ride high, UK pension funds have big surpluses. They have therefore cut back contributions, giving profits a significant boost. As profits have pushed up the stock market, it can be seen that the whole system is circular and has a built- in tendency to overshoot.

By abolishing ACT, Mr Brown has sharply reduced the long-term returns to pension funds. No one seems to mind as the stock market forges ahead, but once it stops, contributions will have to make up the difference. The stock market has thus an even greater tendency to overshoot.

This will have a direct impact on volatility of both the economy and tax revenues. The economy seems able to take relatively small swings in the stock market in its stride. But a large sustained fall, as has occurred in Japan, has a pronounced and depressing impact on the economy. Recessions induced by falling asset prices are severe: tax revenue falls steeply and spending on unemployment rises, and the budget deficit rises more sharply than usual.

The problem the Chancellor has created is that the fall in profits will be exaggerated by the need to increase contributions to pension funds. Actuaries Bacon and Woodrow have warned that up to 25 per cent of UK companies could be forced to put more into their pension schemes because of the abolition of ACT, with the shortfall being as much as pounds 5bn. A market crash will no doubt raise the sum further.

The Government's "golden rule" indicates that it aims to borrow no more than 1.5 per cent of GDP a year over the cycle. Its aspirations for monetary union with Europe suggest that the maximum it can afford to borrow in any one year is 3 per cent. If it is to achieve these targets, it must either run a large surplus at the peak of the cycle, or avoid volatility for both the economy and tax revenue.

As we are at the peak of the cycle and have a budget deficit, it is some way from achieving the first aim, and Mr Brown's first two Budgets have exaggerated the second. The chances of keeping the deficit within 3 per cent of GDP in the next recession look slim. The Chancellor has changed the mix of taxation to reduce the economy's trend rate of growth, to increase the economy's volatility and to render it unlikely thatbudget targets will be met. This is a remarkably bad start.

q Andrew Smithers is managing director of Smithers & Co, an investment advisory firm. Hamish McRae is on holiday.