Markets want Budget that cuts borrowing

KENNETH CLARKE'S promise to 'nurture' the recovery in Tuesday's Budget suggests that he will try not to take too much spending power out of the economy through tax increases and public spending cuts. But this need not preclude a busy Budget: he could take a great deal with one hand and give most of it back with the other.

City economists now expect him to raise a net pounds 2bn to pounds 3bn on Tuesday, a relatively small amount for an economy in which the output of goods and services totals pounds 630bn a year. But this comes on top of tax increases announced by Norman Lamont in March that will raise pounds 6.7bn next year and pounds 10.3bn in 1995/6. They include a rise in the rate of National Insurance contributions and the imposition of VAT on heating fuel.

The reaction of the financial markets to the Budget measures will depend to a large degree on their impact on the Treasury's forecasts for government borrowing. The Chancellor will remember that the markets were much more worried by his predecessor's forecast of a pounds 50bn borrowing requirement in March than they were reassured by the tax increases that accompanied it.

The markets will expect Mr Clarke to cut his borrowing forecast even if he leaves taxes alone. The economy is stronger than had been expected in March, which means that tax revenues should be higher and spending on benefits lower than was forecast at the time. This alone may allow pounds 3bn to be cut from the pounds 44bn borrowing forecast for the next financial year.

Most analysts expect the Chancellor to do just enough to bring the borrowing forecast below pounds 40bn next year, but then - like Mr Lamont - to lay in place measures that will raise more money in future years. Economists at James Capel argue that a package raising pounds 2bn next year, pounds 4bn in 1995/6 and pounds 7bn thereafter would cut the borrowing in 1996/7 to pounds 24bn - pounds 11bn less than the Treasury predicted in March.

But raising taxes is not the only way to cut public borrowing. 'Every pound off spending is worth two pounds of tax rises from the market's perception about government toughness,' said Ian Shepherdson at Midland Global Markets.

The Chancellor will almost certainly announce that public spending next year will be below the pounds 253.6bn total set by the Cabinet in July. As well as pleasing the markets, this would help Mr Clarke win over one of his more sceptical audiences: the Conservative right. He will be helped by the recent good news on inflation, which looks set to remain much lower than had been expected in March. This means the same amount of public sector services can be bought for less cash. If inflation next year was assumed to be 3.5 per cent rather than the 4.25 per cent forecast in March, the spending total could be cut by nearly pounds 2bn.

The Chancellor may also be able to cut the spending total by reducing the pounds 7bn contingency reserve for next year, but not allocating the reduction fully to departmental budgets.

Given this background, what specific measures might the Chancellor be considering?

Income tax

No-one expects the Chancellor to do anything so obvious as to increase the basic rate of income tax. Instead, he may restrict the value of personal tax allowances - the slice of income on which tax does not have to be paid - to the lower tax rate of 20 per cent. This would cost 25 per cent taxpayers pounds 172 a year and 40 per cent taxpayers pounds 689 a year.

Restricting allowances to 20 per cent would raise pounds 5bn, some of which could be handed back by increasing the threshold at which people move from the 20 per cent to the 25 per cent band, perhaps sufficiently to establish 20 per cent as the new 'basic rate'. This has already been done for the married couple's allowance.

More audaciously, the Chancellor could even cut the lower income tax rate below 20 per cent and restrict allowances - including the married couple's allowance - to an even lower rate. This would give him even more scope to widen the lower income tax band and would would hit some 25 per cent taxpayers quite hard.

The least exciting option to raise revenue from income tax would be to fail to increase tax allowances and thresholds in line with inflation, pulling some people into higher tax bands. This would raise pounds 560m next year and pounds 780m in 1995/6.

VAT increases

On Thursday, the Chancellor appeared to rule out an increase in the 17.5 per cent VAT rate. He is also unlikely to impose the full rate of VAT on fuel in a single year, because the cost of compensating the less well off would rise sooner than revenues. The likeliest changes are an extension of VAT to books, newspapers and magazines, raising pounds 1.1bn. Other items that could be brought into the net include food, foreign travel, domestic passenger transport, water and sewerage.

Mortgage tax relief

Tax relief on mortgage interest payments, which will cost pounds 4.3bn this year, is a likely Budget target. Norman Lamont announced in March that the relief would be restricted to the 20 per cent income tax rate from April, but this rate could be reduced further or the pounds 30,000 limit reduced.

Social security

The pounds 80bn social security budget is the largest slice of public spending, and one of the most rapidly growing. The Budget will target certain benefits more tightly, transfer some costs to employers and perhaps encourage people to opt out of state schemes. Unemployment benefit will expire after six months, at which point people will move on to means-tested income support. Tougher tests will be applied for entitlement to invalidity benefit and the age at which women are entitled to the state pension will be steadily increased from 60 to 65.

Companies will also be forced to pick up the pounds 1.4bn bill for statutory sick pay and industrial injuries pay, but that should be offset by a compensating cut in employers' national insurance contributions.

Company taxation

Companies pay advance corporation tax (ACT) on dividends, which they can set off against tax on their profits. But if dividends exceed UK profits because they arise from overseas operations, the company may be unable to claim full credit.

This surplus ACT creates a bias against overseas investment and encourages companies to move headquarters overseas. The ACT rate was cut from 30 per cent to 25 per cent in March to reduce this problem. The Government is expected to allow special dividends to be paid out of foreign earnings.

Pensions

The pensions industry is worried that the Chancellor will reduce or abolish the tax credits enjoyed by pension funds on dividend payments, currently 20 per cent. According to R Watson & Sons, actuaries, this would raise less than supposed as companies claimed corporation tax relief on increased pension contributions.

The method of pensions taxation may be changed so that contributions will not be tax-deductible, but the pension payments themselves are not liable to tax.

Excise duties

Duties on alcohol and tobacco could be raised by more than the rate of inflation.

Private finance

The Chancellor will want to give extra momentum to the involvement of private finance in public infrastructure projects. It is hoped that this will defuse some criticism of cuts in public infrastructure spending.

On Wednesday the Independent will provide readers with the most comprehensive and analytical coverage of the biggest Budget in British history - with 16 pages of news, reaction, comment, photographs and graphics on how the changes in the Budget will affect individuals, businesses and families.

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