Expert View: Has the Treasury got a tax bombshell hidden away?

In a few weeks' time, the Chancellor will present his Pre-Budget Report. It's unlikely that there will be much of a change from the numbers presented in the March Budget. The Treasury should publish relatively optimistic growth forecasts, with borrowing numbers that show the Government will meet its key fiscal rules.

In a few weeks' time, the Chancellor will present his Pre-Budget Report. It's unlikely that there will be much of a change from the numbers presented in the March Budget. The Treasury should publish relatively optimistic growth forecasts, with borrowing numbers that show the Government will meet its key fiscal rules.

We don't expect to have too much of a problem with the new economic forecasts. That's largely because we think activity data show growth is slowing in an orderly way rather than falling off a cliff. There will be no late-1980s slowdown in house prices and consumer spending.

Nonetheless, Treasury projections for the public finances are likely to be a cause for concern. There are a couple of reasons for that. First, the starting point is worse than is widely believed. The Chancellor's "Golden Rule" for the public finances, which means that expenditure should be at least matched by current tax receipts over the course of an economic cycle, is already being broken.

If you add up all of the cash deficits and surpluses that the Treasury reported/projected in March for 1999-2000 to 2005-06, then a cumulative deficit of £1.1bn is obtained. The Treasury says there is a surplus of £11bn.

To get this figure, the Treasury has to use a rather strange interpretation of the rule. It converts budget surpluses or deficits into a percentage of GDP, using the GDP figure for the year in which the deficit or surplus was recorded. It then adds up all of these percentages and works out a cash equivalent by multiplying the resulting figure by GDP in the final year of the economic cycle. Now, because the economy is projected to grow over the cycle, this means the largest possible GDP figure is used. That boosts the cash equivalent of the surpluses recorded at the cycle's start.

It's true that any recorded or expected deficits will also be boosted, but the net impact of this manipulation is to make it appear that a reasonable budget surplus has been achieved over the course of the cycle. This is illusory. The actual surpluses and deficits recorded and expected net to a deficit of £1.1bn. Turning a recorded cash surplus in the first year of the cycle of £19.3bn into a surplus of £26.1bn via an interesting statistical manipulation might help to produce a budget surplus over the economic cycle. But does the extra £6.8bn obtained exist? The answer to that has to be "no".

But that's not the end of the bad news. Our calculations suggest the Treasury forecasts for corporation tax receipts in 2005-06 and 2006-07 will be undershot by £5bn per year. Our models suggest that corporation tax receipts will grow around 5 per cent next year, rather than the 20 per cent plus growth the Treasury has factored in. Income tax receipts should undershoot the Treasury forecast for 2005-06 - though the undershoot will be closer to £2bn.

Put all of this together, and the Government will have to borrow around £37bn in the next financial year rather than the £31bn that is factored in. More important, it's enough to force the Government to do something about it if it is to meet its fiscal rules in the medium term. And that means tax increases. We expect employee National Insurance contributions will have to be increased to cover the shortfall.

We don't expect this tax issue to be addressed in the Pre-Budget Report. It's more likely the Treasury will stick with borrowing numbers similar to those outlined in the March Budget, hoping revenues from corporation tax and income tax increase. But by this time next year, after the election, when deterioration in tax flows is clearer, measures will have to come in to address the revenue shortfalls. Taxes are going up: but not yet.

David Hillier is chief UK economist at Barclays Capital