Clarke can have it all ways

IF A WEEK is a long time in politics, in economics a few months are an age. Back in the early summer, the Chancellor was supposedly boxed in. Inflation was rising and the Governor of the Bank of England was pressing for an interest rate rise. Meanwhile, deteriorating Public Sector Borrowing Requirement (PSBR) prospects supposedly ruled out tax cuts. All along this seemed to me to be much too pessimistic a scenario. It is now widely believed that Kenneth Clarke will cut both tax and interest rates. How has he done it? Is this just another example of political imperatives overruling sober economic judgement?

Political considerations are at the root of tax strategy. People always ask: "How much scope does he have to cut taxes?" or "How much room is there?". It is as though they have been taken in by official Treasury publications that used to lay down a schedule of borrowing numbers that included a specific allowance for tax cuts, as though they were the outcome of remorseless arithmetic.

To my mind, to speak of "the scope for tax cuts" puts the cart before the horse. There will be tax cuts in November. They are the starting point for the Budget arithmetic, not its conclusion. The Budget arithmetic is about two related questions - how much can he get away with, and how will it be financed.

The anxiety about the borrowing numbers will serve to keep the size of immediate tax cuts in check and also to ensure that they are financed by spending "cuts" rather than merely added to the borrowing totals.

Spending reductions? With an election on the horizon? It seems scarcely credible. But it should be easy, if only the Chancellor musters the will. For I am not talking about real cuts but cuts from a planned increase.

Every year, the spending numbers include a substantial unallocated sum, the Contingency Reserve, which is intended, as its name suggests, as a reserve kitty to meet unforeseen spending. In the event, it has usually been depleted deliberately in order to add to departmental spending programmes. This year's kitty was pounds 3bn. It is unlikely to be spent. The kitty already allowed for in the plans next year is pounds 6bn. All the Chancellor has to do is resolve not to raid this kitty and he has "reduced" spending by pounds 6bn.

In practice, he will probably need to keep some money aside, say pounds 2bn to pounds 3bn, but this will still leave him with pounds 3bn to pounds 4bn to fund tax reductions. Doubtless, he will also try to squeeze public capital spending and try to crank up the private financing initiative to get more capital spending out of the public spending totals. But anything he "saves" could readily be taken up by the odd few billion ostentatiously added to politically sensitive spending programmes on health and education. Still, the reduction in the Reserve can be just about enough to fund the equivalent of a 2p reduction in the basic rate of income tax.

Yet this doesn't sound enough to give the Tories even a squeak of getting re-elected. They will have to go further and announce a forward plan for tax reductions in the years ahead, in the way that Mr Lamont did for tax rises. But this raises the same issues. How is it to be financed? The answer, it must be, is by spending restraint.

Even then the Chancellor runs into an objection. It is believed that large tax cuts would be dangerous because they would boost consumer spending and might require higher interest rates. This is seriously misguided. Economic growth and inflation together produce an increase in tax receipts without any rise in tax rates. If this money is not spent by the Government, it could be given back to the taxpayer without fear of inflationary spending surges.

It is only when the extra receipts are the product of an unsustainably rapid surge in growth, or are used to increase spending and cut taxes as well, that the problem arises. Taxes are not now rolling in because of unsustainably fast growth, and memories of the Lawson boom are sufficiently fresh for the Chancellor not to take risks with big tax cuts without a spending squeeze.

This is where interest rates come in. How can he cut them if he is also cutting taxes, people ask. Well, if all the Chancellor is going to do is repay to the taxpayer the fruits of steady economic growth, while keeping public spending in check, then he is not relaxing fiscal policy and not restricting the scope for interest rate reductions.

Of course, the markets will scrutinise the fiscal numbers like hawks to make sure that the arithmetic has not been done with the help of smoke and mirrors. Moreover, we would be able to have even lower interest rates if the Chancellor gave no tax cuts at all and used all of the benefits of economic growth to reduce the PSBR. Putting political considerations aside, there would be a strong case for doing just that. Still, as the economist said to the astrologer, you can't have everything.

And the scope for interest rate reductions is much greater than most people recognise. They are mesmerised by the tough stance taken by the Governor of the Bank of England, and by the prevailing pessimism of the past year. But Mr George is not a perennial killjoy, rather a tough inflation fighter. And it is inflation that holds the key to interest rates next year.

This year's rise to almost 4 per cent on the headline measure has unsettled many people. But it is thoroughly misleading. If the term had not already been sadly misappropriated by a former Chancellor, I would be tempted to describe it as a blip. Headline inflation has been distorted upwards by higher mortgage rates and higher indirect taxes. True, the underlying rate has also risen, but that has been caused by last year's surge in commodity prices and the weakness of sterling. These are one-off events, and their effects are now fading steadily.

In the past, though, they would have caused a continuing inflationary problem because they would have fed into wage settlements and that would have led to a wage-price spiral. But this time things are different. I know that the Ford workers have asked for 10 per cent and the Tube workers for 6 per cent. But the fact is that average earnings growth is running at only 3.5 per cent with no real sign of picking up, despite the fact that headline inflation is reaching 4 per cent. If it were not explicable in terms of the collapse of inflationary forces that I have been proclaiming for years, I would describe it as a minor miracle. Its significance for inflation is profound. Without wage inflation there won't be any price inflation.

This year's wage restraint means that inflation will fall next year. And if, as I believe, it falls well within the Government's target range, then even the Governor will sign up to interest rate reductions.

So next year is shaping up extremely well for the Government - lower inflation, lower taxes and lower interest rates. Too good to be true? CalI me naive, if you like, but I am pinning my faith on Mr Clarke, even in the run-up to the election. I know he is a politician above all, but he has the knack of marrying political expediency with good economic judgement. He was tough enough to face down Mr Eddie George over interest rates and I think he will face down those calling for both spending laxity and large tax cuts.

When Napoleon was asked what quality he prized most in his generals he replied that they should be lucky. Mr Clarke is lucky. For that he deserves not blame, but thanks.

q Roger Bootle is chief economist at HSBC Midland. Hamish McRae is on holiday.