Higher taxes may mean lower base rates

The Chancellor's speech at the International Monetary Fund meeting last week contained two interesting new nuances. First, he committed himself to cutting back 'current' government expenditure in the Cabinet spending round that is now under way. The unspoken implication was that capital spending would be left relatively unscathed in this year's purge, which is a relief.

Capital spending is clearly becoming the focus of special political attention. Not only is the 'private finance initiative' - under which private money will be injected into large capital projects such as the Channel tunnel rail link - seen by ministers as a 1990s revolution equivalent to privatisation in the 1980s. In addition, the Treasury is due to publish with the Budget the first complete analysis of the split between current and capital spending, possibly with a view to suggesting that high public borrowing can be justified if it is the Ecounterpart to public investment.

It would not be too surprising if the Chancellor were starting to manoeuvre away from THER write errorthe commitment to a balanced budget, which has theoretically been the Treasury's fiscal objective ever since Lord Lawson introduced it in the mid-1980s. An alternative to a basic housekeeping objective like budget balance (which has no economic coherence that anyone has ever been able to explain to me) is the slightly more sophisticated 'golden rule of public finance', which is the benchmark for government deficits in Germany. This states that the average government deficit in the course of an economic cycle should be equal to public investment, thus ensuring that public assets rise in line with public debt, and that the net worth of the public sector is left unchanged.

The advantage of this rule from the Government's perspective (apart from the fact that it has a modicum of economic justification) is that it does not require the public sector borrowing requirement to be entirely eliminated, even in the medium term. Admittedly, there are huge practical problems in applying the golden rule, such as deciding whether spending on areas such as education and defence should be counted as current or capital spending. These ambiguities mean that the golden rule is subject to a great deal of creative accounting.

Justified borrowing

But on my rough calculations, the Government is adding around pounds 15bn- pounds 20bn a year to its capital stock, so a PSBR of about this amount (about 2.5 per cent of GDP) could be justified under the rule. If the Chancellor can sketch out a path for the PSBR in the Budget which drops to this figure by the end of this Parliament, he can claim he is adhering to the golden rule.

Norman Lamont bequeathed to his successor sufficient tax increases to reduce the PSBR, on his central economic forecasts, to about 3.8 per cent of GDP by 1997/98. This implies that Kenneth Clarke needs to find further tax increases (or cuts in current public spending) of a little more than 1 per cent of GDP - pounds 7bn - in order to achieve my representation of the golden rule. With a slightly more generous interpretation of what constitutes public investment, he could make the golden rule less arduous, and thus whittle down the required tax increases a little. Nevertheless, some increases would probably still be needed.

And here we come to the second interesting snippet from the Chancellor's IMF speech. He once again clearly hinted that he intends to raise taxes, and expressed a definite preference for indirect taxes, rather than extra income, investment or savings taxation. (I hear, incidentally, that the Chancellor's special adviser, Tessa Keswick, joked last week that 'direct taxes are those the Government introduces this year, while indirect taxes are those delayed until next year'.)

As this newspaper revealed last Friday, the Treasury has asked British Rail to study the consequences of imposing VAT on transport. This, together with the IMF speech, suggests that the Chancellor may be contemplating a frontal assault on the Tory Party's anti-VAT brigade, which must shaking with fury at the prospect of VAT on fuel and rail fares simultaneously.

I know not whether he will have the nerve, or backbench support, to do it, but if taxes must be raised at all then Mr Clarke has every economic justification for widening the VAT base yet again. In fact, there is a strong economic case for imposing VAT on food, house-building and children's clothing as well as transport and fuel, with the adverse effects of all this on low-income families being offset by higher social security benefits and income tax thresholds. But now we are entering fantasy land.

The real possibilities for VAT on 30 November are transport, books, newspapers and financial services (perhaps through some form of surrogate tax on bank deposits). Those who have not always viewed Mr Clarke as a stickler for the scrupulous observance of economic theory will see his decisions in this area as an interesting test case. The cynical conclusion would be that his recent remarks are merely setting up his party for a collective sigh of relief when he does nothing on Budget day, but we shall see.

Of more interest to the financial markets at present is whether the Chancellor will combine his likely tax increase with a base rate cut around Budget time. At the current stage of the economic cycle, there are good grounds for saying 'when in doubt, default to an unchanged monetary policy'. After all, there has historically been a tendency to over-stimulate the economy during upswings. But the impending tightening in budgetary policy makes things look a little different on this occasion.

The crucial question for the Treasury is whether the adverse effect of higher taxes on activity over the next couple of years will more than offset the lagged beneficial effects of earlier cuts in base rates. In other words, is there sufficient monetary stimulus already in the pipeline?

The graph is intended to help answer this question. It shows the impact on GDP growth of changes in budgetary and monetary policy separately, and then adds the two together to derive a figure for the total impact of policy changes. A word of warning is in order - these figures, which are derived from simulations on six different macro- economic models including those of the Treasury and Bank of England, are necessarily very broad-brush. Nevertheless, there is unfortunately no better way of addressing the problem in hand.

Powerful boost

The graph shows how powerful the recent policy boost to growth has been, amounting to over 3 per cent of GDP in both 1992 and 1993. These figures may seem implausibly large, but remember we are talking here about a cut of 9 per cent in base rates, along with a quadrupling in the budget deficit. No wonder the economy has recovered]

From now on, things will be different. On the basis of the Lamont tax and spending plans already announced, budgetary policy will subtract about 1 per cent a year from GDP growth in both 1994 and 1995. The delayed effects of the Lamont base ratEe cuts will be more than sufficient to offset this next year, buTHER write errort by 1995 the overall policy thrust will have turned negative.

If Mr Clarke adds a further dose of fiscal tightening to the Lamont measures already announced, he will need to lower base rates again to avoid a significant tightening in the overall policy thrust in 1995 - the likely pre-election year.

(Photograph omitted)