Economic View: The taps will be turned off

How is the Chancellor going to dig himself out of this one? Admit he has got his sums wrong? Blame it on the war? Or bluster through because we are still growing faster than most of the rest of the developed world?

How is the Chancellor going to dig himself out of this one? Admit he has got his sums wrong? Blame it on the war? Or bluster through because we are still growing faster than most of the rest of the developed world?

We will learn more of the story in the Budget on 9 April, by which time we must hope that the course of the Iraq conflict and reconstruction should be clearer. But already it is evident that public finances have been going badly awry, with revenue falling well short of Treasury estimates. We were told things were going wrong last November in the pre-Budget report, when the borrowing requirement for this year was doubled to £20bn. In the last Budget, tax revenues were projected to rise by 2.6 per cent. Now we know that tax revenues for the first 11 months of the financial year were up by just 0.7 per cent, while income tax was down.

In addition, there is a war to pay for. Last Thursday Gordon Brown disclosed that he had allocated an additional £3bn for this, plus £120m for emergency reconstruction. Set aside the $75bn (£48bn) sought by President Bush, these UK numbers seem far too low. Proportionately, our bill would look more like £10bn and of course there are huge unknowns ahead, which are likely to push the bill still higher.

So what will he do? The same as any home owner who has a biggish mortgage and an expensive family to support, and who faces a fall in income. He can either borrow more, try to increase income, or cut spending. My guess is that he will do all three.

He is certainly going to borrow more. That £20bn for this year will surely have crept up, and borrowing for the new financial year, the one that starts this coming week, was already projected to be a bit higher. But by how much? You can see the budget projections for net borrowing in the first graph. Sure, we were going from surplus to deficit even on previous projections, but by the standards of the early 1970s and early 1990s we look fine.

The trouble is that those surges in borrowing led eventually to financial and political disaster. In the case of the 1970s, there was the IMF bailout and the end of the Callaghan government. In the 1990s there was the expulsion from the exchange rate mechanism and the end of the Major government.

True, other developed countries are also heading into deeper deficits, but I can't see Mr Brown wanting to go too far down this route. My guess is that the acceptable limit for borrowing would be around 3 per cent of GDP, maybe a touch higher, or a figure of about £33bn. That would still leave the UK deficit lower than that of the US (which looks like hitting 4 per cent of GDP), Germany and France. So there is a bit of leeway there. However, I don't think that would be enough.

Increase taxes? Well, Mr Brown is already planning to increase taxation by £30bn this year. You can see the steep planned increases for both spending and taxation in the second graph, but again these are based on what are now out-of-date forecasts.

Revenue was already projected to rise by £30bn, from £400bn to £430bn – see bottom line of the big table, which shows the biggest sources of revenue for the last year, for the one just ending, and for the new one.

But you have to ponder two questions. One is whether it is really sensible to increase taxation by such a huge amount when the economy is so fragile? The other: can the planned increases already announced raise that £430bn figure?

The questions conflict. Of course it is not sensible to be raising taxation at this time, but it is very hard to see how the Chancellor can go back on his plans to increase national insurance contributions. As you can see, they are a huge revenue earner. But it is just possible that he might try and rebalance the taxation, cutting some taxes and raising others, to get his £430bn.

The trouble is that there have been so many clever wheezes to squeeze revenue up that there are no easy ideas left. If you look at what he has done in the past, there is no scope to push things further. Increase airline taxation? Not a great time to do that. Tax pension funds harder? Ouch. Hit the insurance companies? Not the right thing to do right now. There is always income tax and there is always VAT, two huge earners. But to raise either would be to acknowledge failure.

My guess is that the old stalwarts of petrol, tobacco and booze will all go up by rather more than inflation. Not original, but a way of making the best of a bad job.

Cut spending? I think that has to happen. For the last year parts of the public sector, not all, have been flush with money. It comes with strings, for the Treasury is trying to micro-manage the entire public sector. Talk to anyone involved and they say as long as we can find some scheme that the Treasury approves of, we can get plenty of money. The trick seems to be to do what you always wanted to do and dress it up as a Treasury initiative. Now, I suspect, the taps will be turned off. The money will eventually flow but the Treasury will use its value-for-money tests to slow the rate at which the dosh is dished out. Spending won't be cut as such. It is just that the hoops will become harder to jump through.

So the facade will remain intact. The reality, though, will be much more austere. And that, I predict, we will not like at all.