Hamish McRae: We feel good but it's fragile

Romano Prodi's comment last week that Europe's growth and stability pact is "stupid" highlights the difficulties facing EU finance ministers in several countries, including the big three: Germany, France and Italy. All face a ballooning fiscal deficit as a result of falling tax revenues and rising social payments.

But how about us? Are we immune? Next month comes our pre-Budget report, which gives us the best clues to the delights or horrors in store in the spring Budget. This year the planning is particularly fraught for two reasons. One, the economic outlook is very uncertain, for although the UK has come through the downswing in relatively good shape so far, the world economy is by no means through the woods yet; and two, we are embarking on a huge spending programme that may or may not deliver results and which in any case may prove hard to finance.

As the EU big three have discovered, an economic downturn affects the budget in two very simple ways: it cuts tax revenue and it increases spending. So far, Britain has had something of the first, for revenues – particularly from company taxation – seem to be running below expected levels. Some other taxes such as capital gains are not doing too well either, for obvious reasons. But the revenue side has held up pretty well, because employment and consumption have both remained strong. Income tax and VAT are the two largest sources of revenue and both so far have been fine. Employment this year hit an all-time high, and earnings are still rising by close to the 4 per cent annual rate. And consumption, which pulls in excise duties on drink and fuel as well as VAT, is also still very strong.

So as a rule of thumb, the smaller taxes (such as capital gains tax) may be in trouble but the big ones (such as income tax) are all right. There are stories of there being a "black hole" of £7bn in missing revenue but that sort of shortfall is manageable. The Government may well turn out to be several billion down on its revenue forecasts – that is one of the things to watch for next month – but there is, as yet, no black hole. We are mercifully not in the position of Germany, which is having to put up taxes in the teeth of recession. Its finance minister, Hans Eichel, has just acknowledged that the country will probably break the 3 per cent deficit ceiling of the European Stability and Growth Pact – insofar as the pact will still exist following the attack by Romano Prodi. Anyway, as far as we are concerned, there is enough leeway to cope with some revenue shortfall. Or at least there is at the moment.

On the spending side the picture is different. There has been no significant excess of spending over and above planned levels. There are some chunks of spending that are beyond the control of government in that they are determined by the business cycle. Thus the cost of unemployment benefit, once the level of payment is fixed, changes according to the number of people entitled to claim it. Interest charges on public debt change in response to movements in the financial markets. But both unemployment and interest rates remain low.

The problem is, rather, that during Labour's first term of office there was a culture, if not of parsimony, at least of containment. Ministers won Brownie points for coming in under-budget, or for finding ways of running their departments more efficiently. Now that has gone. I would not say that the brakes are off but several departments are seeing very large real increases in their budgets, which has created an early Christmas party.

As a result, instead of being able to rely on departments underspending, the Treasury has to worry about getting value for money. I understand that Gordon Brown has the gravest doubts about the ability of several departments to be sensible with the increased cash they have been allocated, but given political realities there is not much to be done about this right now. We know mistakes are being made but we won't know which ones they are for some time.

This leads to an even bigger issue: will the UK retain a tax advantage over the rest of Europe? In the past few days it has been revealed that taxes here are rising faster than anywhere else in the EU. This reverses a general downward trend in UK taxation since the early 1980s and runs counter to a similar downward trend in public spending over the same period (see line chart above). In any case, while we remain towards the bottom of the European spending league, we are not at the bottom and we have to compare ourselves against the rest of the developed world, not just Europe (see bar chart). The obvious danger is that we end up with no tax advantage and services that are still relatively poor by European standards.

The lags in response to changes in public policy can be both long and surprising. Most economists have been surprised about the ability of the economy to sustain a relatively strong pound with a quite modest current-account deficit, and yet keep growing faster than most competitors. The Government still benefits from that feel-good factor both in terms of its reputation and its revenues. But most of the business people I have spoken to recently feel that our competitive advantages over tax and regulation have been narrowed sharply by this government. These advantages still exist, but I don't think the Government realises quite how fragile this lead has become. It assumes that economic success is a given. It isn't. And we will get more of a clue of the dangers next month when we learn how Mr Brown is trimming his plans to cope with tougher times. Meanwhile, he should be glad he is not in the situation of Mr Eichel or, come to think of it, Mr Prodi.