Forecast finds tax cuts this year affordable

Chancellor Kenneth Clarke could afford to cut the basic rate of income tax to 20p in the pound in his next budget without tearing a hole in the public finances, a leading economic forecaster has said.

The 4p cut in tax rate would still leave the public sector borrowing requirement in 1997/8 below its level this year. By 1998/9, the PSBR would fall to under 2 per cent of GDP.

This projection is made, though not recommended, in the latest forecast from the National Institute of Economic and Social Research. It calculates that the cumulative effect of public spending cuts and tax increases since March 1993 have lopped pounds 30bn off next year's PSBR (1996/7). Mr Clarke could cut taxes in November by the same amount he did in last year's budget and still leave Britain on course to be the only large European economy to meet the fiscal qualification for European monetary union.

However on the downside, Martin Weale, NIESR's Director and a member of the Treasury's Panel of Independent Forecasters, warns that the taxpayer will end up having to pay through the nose for the big cuts in public investment in the November budget - supposed to be offset by capital spending financed by the private sector. But higher borrowing costs faced by the private sector firms who undertake the projects would ensure they eventually cost the taxpayer more than if the Government had financed the investment itself.

The Institute also says that: "One of the more remarkable aspects of the performance of the UK economy in the recovery is that unemployment has been able to fall so far without there being any significant upward pressure on earnings." However, it forecasts that the growth in average earnings will increase from 3 per cent in 1995 and 1996 to 5 per cent in 1997.

The latest survey from the Confederation of British Industry shows pay awards edging up in manufacturing but falling in services in the three months ending January. Average settlements for manufacturing firms in the quarter ending December rose from 3.7 to 3.8 per cent. Those for service firms fell from 3.7 to 3.5 per cent.

On interest rates, the National Institute warns that further cuts will lead the Government to miss its inflation target in 1997. Despite the green light the Bank of England appeared last week to give to further rate cuts, NIESR says that even a modest quarter point reduction to 6 per cent will allow underlying inflation to rise to 3 per cent next year above the Government's target.

It recommends replacing the inflation target with a policy objective that takes output into account as well. This could be achieved by targeting nominal GDP, the current value measure of gross domestic product. This would make for greater flexibility in policy since demand could be increased if inflation or output were unusually weak.

In practice, this was what the Government appeared to be doing. "Despite the Government's stated policy aims, it looks very much as though Keynsian fine-tuning has re-emerged, with the interest rate being adjusted ... with the aim of achieving lower unemployment and faster growth in output." So an explicit change in the target to nominal GDP would make for more coherent policy.