Economic Life: Now the banks are in order, the public finances will take a hit

Now that some sort of order has been restored to the money markets (if not to bank share prices), expect the disorder to move to the public finances. There will be an obvious increase in public debt as and when the banks are recapitalised but this will be quite separate from the underlying rise in the deficit as spending continues to rise and tax revenues decline.

This is an important intellectual distinction. A deficit that arises from a subscription to the capital of the banks will eventually be worth something, even if the shares won't be worth much. Actually any money subscribed will almost certainly be repaid and at a decent return. But a deficit that arises from the Government's normal activities is worth very little, even if it is notionally for investment of some sort. We will not know the full horror story (or more accurately the Treasury's assessment of the full horror story) until the pre-Budget report, out in the next few weeks. Meanwhile it is clear that there has been a serious deterioration in the underlying situation of public finances.

So how serious? Well the government deficit is the gap between two very large numbers so that even a proportionately small fall in tax revenues or a proportionately small rise in spending has a massive effect on the outcome. Already this year spending is running above budget forecasts and revenues below. We don't yet have the September figures but the pattern of borrowing up to August is running way ahead of last year. And that was before the real deterioration of the economy that now seems to be talking place. The economy was pretty stable until July and though it may have tailed off a bit in August this would be too early for slower growth to show through in lower tax revenues. But now I am afraid, things are getting worse.

Start with the revenue side. There are four really big sources of revenue: income tax, national insurance contributions, VAT and corporation profits tax. Income tax revenue is already flat and will get much worse because such a high proportion of the revenue comes from very high earners. Roughly a quarter of income tax comes from the top 1 per cent of earners, whose income will be hit as City bonuses fall. That effect has not come through yet but will in the first quarter of next year, i.e., the final quarter of this tax year. NICs depend on total employment and up to August was not doing too badly because employment has remained strong, even though unemployment was rising. Now the reasonable expectation is that employment will start to decline, and though maybe only slowly, that will cut NICs revenue.

VAT obviously depends on our spending. The flow of revenue from that too has not been too bad so far this year. Retail sales have not fallen off a cliff; other services have kept going reasonably solidly. Estimates each month from the National Institute on services output have suggested that it is still creeping up. The trouble is that it will now surely flatten as consumers cut back. It won't collapse, at least I don't think so, but it won't be great.

Corporation tax revenues, on the other hand, will fall sharply. In the past something around a third of corporation tax has been paid by financial companies. Finance has not, you might say, had a great year so far. We won't have hard revenue numbers until January and there will be offsets from other industries that have done well. But overall, corporation profits will probably be down and if that happens revenue will be down too, maybe by quite a lot.

Put all this together and it is possible that tax revenue in the second half of this year will be lower than the comparable period last year. The Treasury is not accustomed to a world where tax revenues actually fall. It won't have happened within the memory of most of its officials and it will be interesting to see how realistic they are when the PBR comes out.

Now look at the spending side. This year so far spending has been above budget estimates. I have not managed to get to the bottom of why that is happening. If growth is slower than forecast and unemployment higher, you would expect outgoing on benefits to be up. But investment seems to be higher than budget, which suggests bad control. One particular bit of bad news is inflation, for the September retail price index figure is the one used for re-rating benefits, pensions and the return on index-linked gilts. For all this fuss about the new harmonised consumer price index, the one that matters for public finance is the RPI. As you can see, at 5 per cent that is the highest since 1991, so a large chunk of public outgoings will be tied to an exceptionally unfavourable (for the taxpayer) number.

The Government can squeeze back some of its spending and it can juggle the figures a bit by trying to get tax revenue in earlier and paying its own bills a bit later. I am getting more and more stories of tax gouging, as an increasingly desperate Revenue is trying to make taxpayers advance their payments and we are starting to hear the squeals of spending departments that find themselves cut back.

But the Government can only trim at the edges. It cannot affect the big picture without either putting taxes up or explicitly cutting spending. Net of all the new banking-related debts, I would be relieved if the budget deficit this year comes in at less than £65bn, some £15bn above the revised estimates.

But the really worrying thing is not this financial year but the next and the years beyond. If we compare what has happened to public borrowing in the past in contrast to the Treasury estimates about the future path with some from Capital Economics. Now we will not have a deficit of £120bn in 20011/12 and 20012/13 because that would be stretching the boundaries of what a government can safely borrow. On my back-of-an-envelope tally this would mean that for every £10 the Government was spending it would be raising only £8 in tax. Can't be done. Forget fiscal rules; it would not be credible to the international markets. So either taxes would go up or spending would have to come down.

Is that too gloomy? Well maybe a bit. Capital Economics is basing this on a forecast growth of minus 1 per cent in 2009 and minus 0.5 per cent in 2010. That is quite a bit worse than the mainstream estimates from the IMF and OECD. If you don't trust any official forecasts, try the new ones from ING Bank, which have growth at minus 0.8 per cent next year but plus 1.9 per cent in 2010. Goldman Sachs has a plus 0.6 per cent next year, which would have seemed unduly pessimistic a couple of months ago but might turn out to be right. My own instinct is that an economic recovery could lead a house price recovery, rather than the other way round, for this did happen in the early 1990s. So even if you are gloomy about house prices and expect a recovery there to be delayed until 2012 or beyond, we could still have a plus number for growth in 2009, just, and probably in 2010.

But it is scary. You don't want to go into a global downturn with a huge budget deficit. I am afraid that is just what we are going to do.