Relaxed Clarke on course for tax cut

The Chancellor of the Exchequer is going to introduce substantial tax cuts before the next general election.

With attention on interest rates in the run-up to next week's monthly meeting between the Chancellor and the Governor of the Bank of England, the tax question has slipped out of the limelight. But traders in the City of London are now convinced that lower taxes are a racing certainty. And they are right.

Ken Clarke himself has been busy talking down hopes of lower taxes, speaking about the possibility with all the caution of a central banker rather than as a politician who hopes to be re-elected. He has said repeatedly that taxes will fall when it is clear this can be afforded, and has ruled out big reductions in government spending to finance a tax giveaway.

If it turned out to be affordability alone that determined the size of tax reductions, the Chancellor's scope in the next Budget or two would be very limited. For all the rhetoric about the good shape of public finances, Britain is one of the industrial world's basket-case economies.

Last year only Italy among the Group of Seven industrial countries had a general government deficit bigger than Britain's as a proportion of gross domestic product. Outside the G7, only Greece and Sweden were in worse shape. True, Britain's shortfall is forecast to be sharply lower this year thanks to the tax increases. But it is clear why financial markets have marked sterling as a weak currency.

Last financial year the public sector borrowing requirement - the conventional measure, smaller than the general government deficit because it includes privatisation proceeds and the surplus of public corporations - came in at pounds 35.3bn. This was a shade over the pounds 34.4bn forecast last Budget. The Treasury predicts it will be pounds 21.5bn in the current year, falling to a mere pounds 5bn in 1997-98.

These projections incorporate a contingency reserve that rises from pounds 3bn this year to pounds 9bn in 1997-98. The reserve, in these days of better spending control and fewer overruns, can be thought of as essentially a piggy bank for tax cuts.

Luckily for Mr Clarke, lower taxes financed out of the reserve would not hit the headline PSBR forecast, although they would have an expansionary effect on the economy.

Unluckily, the PSBR is sensitive to small variations in growth and inflation. As a rule of thumb, growth of 3 per cent rather than the 3.25 per cent predicted by the Treasury for this year would add pounds 1bn to the borrowing figure. Higher inflation would raise both revenues and spending in unpredictable ways.

Since the Treasury's average error in forecasting the PSBR in the past 10 years has been pounds 10.5bn, it would not be all that surprising if Mr Clarke had to cope with a deficit well above the forecast.

This sort of calculation about what would be prudent has led most commentators towards an estimate of, say, pounds 3-5bn for tax cuts in the next Budget and somewhat more in a second Budget before the election - a bit from the reserve, a bit from optimistic forecasting, and some juggling between lower income tax and higher corporate taxes.

This would be the sort of Budget that would win the approval of the international financial orthodoxy. For a wayward country like Britain, the financial markets and the International Monetary Fund prescribe fiscal consolidation - unpleasant surgical intervention to slim bulging deficits. The IMF has spelt it out explicitly: lower taxes will have to be earned by reducing spending.

Orthodoxy will lose out in the end. The odds are on big tax cuts that will make us feel good rather than small ones as a reward for being good.

There are three compelling reasons for this. History provides one. All post-war Conservative chancellors have left office implementing a scorched- earth policy on public finances. As the chart shows, the two years after the departure of Conservative governments - including after 1992, when the Government fully expected to be out of office - have been marked by a surge in public borrowing as a proportion of GDP. Incoming chancellors have all inherited a mess.

Take Reginald Maudling's Budget before the 1964 election campaign. His predecessor, Selwyn Lloyd, had introduced two deflationary Budgets in succession, taking unemployment to a new peak of 800,000. With the government deeply unpopular, Mr Maudling decided a boom was just the thing to engineer a virtuous circle of higher investment, productivity and growth. The new Labour Chancellor, James Callaghan, inherited a gaping hole in both the public finances and the balance of payments, with a sterling crisis as a result.

The next handover, from the Heath government in 1974, saw the economy in an even bigger mess thanks to the oil price shock and industrial strife. While the government was not responsible for Opec, expansionary fiscal policy amplified the inflation and balance of payments problems. Chancellor Denis Healey eventually had to call in the IMF to sort things out.

The latest example was the stimulus to the economy in 1991, the year before an election that opinion polls suggested the government would lose. Norman Lamont had to reverse earlier tax cuts with a vengeance after the election, but could not do it fast enough to avert the exchange rate mechanism crisis in the autumn of 1992.

Mr Clarke has seen through his predecessor's correction to the public finances. He is without doubt a sincere politician who would like to do the right thing by the economy. But the weight of political tradition is against him.

The second reason for expecting bigger tax cuts than might be sensible is that the Chancellor has already relaxed his stance on inflation. The formal target is unchanged - 1-2.5 per cent by the end of the parliament - and will soon be extended in an appropriate way. But ever since he overrode the Bank of England's advice over base rates at the beginning of May, Mr Clarke has been insisting that inflation at 3 per cent will be "not much short of a triumph". This has been noted in the City, where analysts reason that if the Chancellor thinks 3 per cent inflation is a triumph, he could easily say the same about 4 per cent or perhaps even 5 per cent. And if he is relaxed about a bit more inflation, he is probably relaxed about a few billion more off taxes, too.

Finally, there is the political pressure from the slash-and-burn right wing of the Conservative Party. These MPs, who think interest rates should stay low, taxes fall and the sterling devaluation that hurts German and Japanese industry a bit of a hoot, make Labour look like the bankers' party of preference.

Mr Clarke disagrees with them. But he is unlikely to run the danger of losing the election by refusing an extra few billion in tax cuts, and thus risk delivering the Conservative Party into the hands of people with views about the economy so fundamentally opposed to his own.