Economics: The time is not right to put up taxes

WATCH OUT. There is a lot of bond market machismo about. If some of the dealers in government gilts, the advisers at the Bank of England and the officials at the Treasury get their way, the Chancellor will show how tough he is by raising taxes in his March Budget. That would be a big mistake. Taxes will need to go up sooner rather than later, but not until the recovery is under way.

It seems particularly odd to contemplate an early increase in taxes such as VAT on spending (which the Chancellor wants to encourage), rather than on incomes (which include an element of savings; because savings are not spent, they do not boost the economy). A budget rise in spending taxes would probably prolong the period in which growth is too slow to cut unemployment, and could even prove counter-productive in cutting the budget deficit.

After all, some of the deficit - maybe as much as two thirds of the predicted 7.5 per cent of national income in 1992-3 - should gradually disappear as growth resumes, tax revenues rise and spending on benefits falls. But timing is all: a tax increase before the forces making for a recovery are clearly established will threaten the virtuous circle.

The case for tax increases rests partly on the view that the recovery is definitely under way. This may be so, but the experience of the last few years should surely have taught policy makers some caution. We have been through periods before when the balance of signals from the economy appeared to be optimistic, only to find hope snuffed out. In the similarly indebted United States, there have been three waves of optimism, but it is still not clear that growth is strong enough to absorb the unemployed people and machines.

The second part of the case for tax increases is that the Chancellor runs the risk of a financial crisis if he does not rein back the deficit. His critics point out that the government deficit will be pounds 44bn on his own forecast. In addition, there is a further tranche of government bonds that are due for repayment. Even allowing for some money from National Savings, it is quite possible that the Government will have to absorb more than pounds 50bn from the markets, or about pounds 1bn a week. This exceeds the likely cash intake of institutions such as pensions funds and assurance companies. Foreigners will have to buy gilts as well.

The shock scenario is that either the price of gilts has to fall sharply to make them more attractive, or sterling has to fall further to make all UK assets more attractive to foreigners. Conventional gilts have a fixed interest payment, so that a fall in their prices pushes up their yield. Any new security issued in the market also has to have a higher yield, thus increasing the cost of funds to companies and the Government. If shares also fall in price, equity finance becomes more expensive. If the pound falls sharply, import prices add a new twist to inflationary pressures.

But these fears about the budget deficit are exaggerated. Britain's public sector financial position is very far from placing us in the poor house. Although the projected deficit is large, it is not unprecedented by international standards. Many small countries (and Italy among the larger ones) have run similar deficits for long periods of time. Nor is the deficit as high relative to household savings as it is in the United States. (I suspect that the UK savings ratio may also be higher than the OECD forecast shown in the graph).

Nor is the underlying position poor. Britain's public debt to income ratio is in the middle rank, a lot lower than it was in the 1970s and early 1980s, and only a third of what it was at the end of the Second World War. One of the benefits of the financial consolidation during the Lawson years is surely that it provides precisely the sort of flexibility needed to run a large deficit during a recession.

The key caveat is that the deficit should be temporary. The final part of the macho argument in favour of raising taxes is that the markets will only be persuaded that the Government will cut the deficit if it starts now. But this seems peculiarly inappropriate when there are strong arguments for delaying any tax rise, and when uniquely the Chancellor has a second Budget this year. He can legitimately hope that the evidence of recovery will be firmly in place by the time of the November/December Budget (the first in the new annual pattern of spending and tax budgets on the same day).

There are ways in which the Chancellor could reassure the financial markets that he will curb the deficit over the cycle. He could publish a clear 'fiscal adjustment' in the Budget documents, mapping out tax rises (or spending curbs) over the medium term. The first tranche could be pencilled in for December, even though any tax increase would affect only the last three months of the 1993-4 financial year.

The second possibility is that Mr Lamont could tie his own hands by introducing clauses of the Finance Bill that trigger automatic increases in taxation when the growth rate exceeds, say, 2 or 2.5 per cent. The United States experience with such attempts to cut the deficit has not been happy, but the British legislature and executive are in effect one and the same, an advantage in few matters save fiscal policy.

When the Government does impose tax increases, it should look at taxes on income rather than spending. This is not merely because it is trying to encourage spending, but also because of the distributional consequences. VAT is currently a modestly progressive tax - it hits rich people proportionately harder than poor ones - because about 40 per cent of consumption (mainly basic items such as food, energy and children's clothing) is excluded.

Any widening of the VAT base is almost bound to be regressive, hitting the poor harder than the well- off. This is both inequitable and likely to curb consumers' spending by more than alternative means (such as increased VAT rates on goods covered already, or increased income tax). The poor spend more of their income than the rich.

The best bet is a rise in income tax or National Insurance contributions. The old Conservative argument that it is better for incentives to put tax on spending rather than income has always been weak, as Enoch Powell has argued. People are not motivated by abstract piles of cash that they cannot spend, but by what they can obtain with the cash.

The famous switch from income tax to VAT in 1979 accomplished little, because the proper calculation of the government tax rate on each extra pound of income (the 'marginal' rate) ought to include the tax rate on spending. For most taxpayers, 25 per cent of the pound goes in income tax and another 9 per cent in National Insurance contributions. Of the remaining 66 pence, 17.5 per cent has to go in VAT. The actual amount of goods and services that people can buy is just 56 pence, and their full marginal tax rate is 44 pence in the pound. An increase in either the VAT rate or the income tax rate will push up the marginal rate.

But that should be an argument for another Budget. Meanwhile, the Chancellor could be imaginative about ways of funding the deficit, including selling bonds which would attract foreigners by guaranteeing their capital value relative to, say, the Ecu or the mark. But no tax increases please. We're in recession.