Taxing questions the Government must face

A senior civil servant told me last week that he thought the Government has almost written off the next election (foolish, if true), and that many members of the Cabinet are thinking more about the post- election Tory leadership contest than about how to escape from their present political hole. But to the extent that they are thinking about the current dilemma, most still see a bonanza tax cutting budget as the one remaining hope of salvation.

In fact, such is the determination of some Conservatives to have another Budget before polling day that there is repeated talk of bringing forward an emergency package to September or October if there looks to be a serious risk of losing a vote of confidence at the start of the last session of this Parliament in November. It is just about feasible to imagine the Prime Minister announcing in his conference speech that the Budget will be unveiled in October, with the election following in November. But would it be worth it?

The Tories need to take on board the fact that the fiscal outlook has worsened so much that Ken Clarke may be simply unable to deliver the goods this autumn. Remember that last year the Chancellor (quite surprisingly) allowed speculation about massive tax cuts to reach fever pitch before the Budget, only to find the modest package of cuts he was actually able to deliver was met with almost universal disappointment.

It will be difficult to avoid speculation about pre-election tax cuts getting even more febrile this year, so there is a case for saying that the risk of disappointment is still greater than last year. In fact, if there is scope for only modest tax reductions this year, or none at all, then maybe there is no point in the Tories hanging on until November. Perhaps they should go earlier to prevent a huge let-down of party morale.

The underlying position of the Government accounts has deteriorated quite alarmingly in the past 18 months. In the 1994 Budget, the Chancellor announced that the public sector borrowing requirement in 1995/96 would be pounds 21.5bn, or 3 per cent of GDP. Furthermore, the plan at that time was to reduce the PSBR to only 1.7 per cent of GDP this year - comfortably inside the Maastricht treaty requirement, and low enough appease all but the most austere of fiscal hawks. I consider myself quite hawkish on the fiscal front nowadays, but I remember writing at the time that there was a considerable margin for error in these figures.

Little did I expect the whole of that margin to be used up so quickly. According to figures just published, the PSBR last year amounted to pounds 32.2bn, fully pounds 10bn more than originally intended. Government spending has once again come in creditably close to the original target, an achievement for which the Treasury should be given due praise. But tax revenue has collapsed relative to the initial forecast. In fact, the three main sources of tax revenue together account for the entire pounds 10bn overshoot in the PSBR - income tax is pounds 2bn below target, corporation tax pounds 3bn below, and VAT an amazing pounds 5bn less than planned.

The Treasury told the Commons Select Committee in March that much of the drop in income tax and corporation tax receipts can be explained by the decline in the tax base resulting from the slowdown in GDP growth and the subdued rate of inflation in the past year. But they admitted that they did not fully understand the decline in VAT receipts, which they hinted might prove permanent. If it does, then it will sooner or later need to be replaced by higher tax receipts elsewhere, or lower levels of public service.

In fact, the only part of the lost revenue which does not have to be eventually replaced is that which can be explained by the drop in real GDP since the 1994 Budget, since this drop will probably be automatically reversed when GDP recovers. On my calculations, tax receipts have dropped by around pounds 6bn more than can be explained by the decline in GDP, and at the moment it seems reasonable to view this as a permanent erosion of the future tax stream.

But this is not all. In the 1995 Budget, the Chancellor announced a further voluntary tax reduction of pounds 4.5bn per annum (of which only pounds 3.2bn impacted in the first year), despite the fact that revenues were falling far short of target. Admittedly, he also reduced the level of future public spending by similar amounts, but a large part of these spending cuts were achieved automatically through lower inflation, or by off-loading items of public sector investment on to the private finance initiative. From the point of view of the sustainability of the government's finances over the long term, not all of these spending cuts should count.

I would therefore argue that the Government's underlying financial position has worsened by somewhere between pounds 6bn and pounds 10bn - let us call it 1 per cent of GDP in round numbers - since the 1994 Budget. The comfortable assumption that the UK will easily qualify for EMU, if it wants to join, is no longer valid. On the definitions in the Maastricht treaty (which do not allow us to count privatisation proceeds or the financial surplus of the public corporations as ways of improving the government accounts), the UK budget deficit next year will be above 4 per cent of GDP, compared with the Maastricht limit of 3 per cent. It no longer seems very likely that an incoming Labour government could take the UK into EMU in 1999, even if it wanted to. And it is one thing to stay out of EMU from a position of strength - quite another to be omitted, like Italy and Spain, because of failure to hit the budget criteria.

As the graph shows, the probable budget deficit of over 4 per cent of GDP next year is much higher than that needed to stabilise the ratio of public debt to GDP, or indeed to hit the golden rule of public finance, which would restrict government borrowing to be no higher than public investment each year. Since Gordon Brown has committed Labour to attaining these objectives, his first Budget is already beginning to look like a large headache, should Labour win.

Furthermore, this is without taking account of what Ken Clarke might do before the election. On the latest PSBR data, there is no longer any solid case for a further injection of tax cuts this November. Every penny the Chancellor now cuts from the tax bill is another penny that some future chancellor may need to raise. Of course, there are some unscrupulous souls who will advise Ken Clarke to go ahead and make substantial tax cuts anyway, if only because they will make the future job of a Labour chancellor that much harder. But it is doubtful whether such tax cuts will get the seal of approval from most mainstream economists in this country. In fact, five of the Treasury's six wise-persons have already warned that sizeable tax cuts this year would be a bad idea. For once, their advice should be heeded.