Economic View: Wake-up call for Dr Pangloss

The mood on the Government's finances seems to be shifting. Praise for managing the economy through the downturn has shifted to longer-term concerns about the sustainability of the Government's spending plans. International organisations such as the OECD and the IMF have sounded warnings on the need either to cut expenditure or raise taxes. And the high monthly tally of government borrowing suggests that in this financial year to April, the Chancellor may miss his target, recently raised to £37bn, by £3bn or more.

This will come as small surprise to anyone who follows the commentaries in this and other newspapers: it has been pretty evident for some time that Prudence had morphed into Dr Pangloss, the Voltaire character who always expected the best to happen in the best of all possible worlds.

However, because public finances seemed not too bad, at least by comparison with most other large developed countries, and because growth continued to remain reasonably strong, the Chancellor seemed able to ride through the bad news. I suppose the fact that the Conservative opposition was so weak helped him too.

Now things have changed. The Tories are ahead in the polls and the combination of higher taxes and concern about the waste of public spending must be contributing to that. Tolerance of higher taxation is conditional on a sense that the money is being used reasonably wisely, and the monthly shortfalls on tax revenue may have something to do with these concerns. Meanwhile, spending overruns continue to hit the news, with councils and defence joining the railways and the NHS in delivering poorer value for money. This leads to two questions: are things really unravelling for the Government? And might there need to be further tax increases before the next general election?

The answer to the first question, I think, is "a bit". And to the second, the answer is "no, but it will be obvious that there will have to be tax increases immediately after the election", and people aren't fools.

It is important not to become too alarmed that the Chancellor keeps missing his borrowing targets. Back in 2001, he was supposed to borrow only £10bn this year (see the first graph above). Again and again the figure was increased, and if he does indeed need £40bn this year, then he will have to accept that no one will trust his forecasts in the future.

But you have to remember that public borrowing is the gap between two huge items and quite small shortfalls in revenue or overruns on spending make the borrowing look awful. Provided there is decent growth, we can ride through all right. The maths are terribly simple. In the case of Germany last year, the deficit will turn out to be 4 per cent of GDP, but since there was zero growth, all the additional debt shows up as a rise in the overall burden that future generations will have to service. Here, we will have a deficit of 3.5 per cent of GDP but growth of 2 per cent. Therefore, the increase in overall indebtedness relative to the size of the economy is modest.

So the worry is not this year; the worry is what the shortfall this year says about the future. Some estimates for public sector borrowing by Roger Bootle, carried out for Deloitte, are shown in the second graph. Mr Bootle gives the Chancellor the benefit of the doubt this year, but he reckons that next year the deficit will rise rather than fall back. The shortfall in tax revenue is structural rather than cyclical.

There is a catch 22 here. Faster growth in the economy will not increase tax revenues by as much as the Chancellor hopes. But if he tries to close the gap by increasing taxation, that will slow the growth, so the revenues still won't rise by enough. Um.

You can see the projected rise in the tax burden in the third graph. By the standards of the early 1980s, when the Tories were grappling with the combination of a world recession and public spending that had got out of control, the projected rise in tax is quite modest. However, these estimates assume the economy is growing at 3 to 3.5 per cent, well above its trend rate, and in the face of rising interest rates. It does not feel right: either spending cuts or tax increases are the only possible outcome, despite the damage that tax increases would do to growth.

But Mr Brown probably does not need to announce tax rises in the next Budget or in that of spring 2005, assuming he is indeed still in the job. The reason is that other countries' deficits will look even worse. The US will have a deficit of 5 per cent of GDP; the big three continental countries somewhere between 3 per cent and 4 per cent; Japan, phew, 7 per cent. We look bad but so does everyone else.

And that leads to a wider conclusion. All developed country governments are following unsustainable fiscal policies. They are loading debts on to future generations of earners, which will in the case of Europe and Japan be smaller than the present one. Society will not tolerate irresponsible fiscal policies indefinitely, just as it did not tolerate irresponsible monetary policies. It took monetary policy out of the hands of elected politicians.

My guess is that we are in the early stages in a reassessment of the proper role of government with regard to finance. Yes, elected governments will be allowed to increase public spending if they also increase taxation to pay for it. But Mr Brown's trick, borrowing a bit more and hoping to get away with it, will seem as odd as the Tory trick of cutting interest rates just before an election.