Budget `97: Politically clever, but the balance is wrong

Like all Budgets, this was a balancing act. The central conflict that Mr Brown had to resolve was between his need to demonstrate that he is a prudent and responsible Chancellor, and his promises to the electorate not to raise tax rates. His desire to show that New Labour will not be bad for financial markets will have been nourished by contact with Treasury officials, stern guardians of the public purse. And then there is the need to hobble the boom before it runs away.

Given that the imperative of balancing the budget coincides with the need to keep total demand in line with supply, most commentators had no difficulty believing the endless leaks about possible tax increases. The only question was how much, and which taxes. Economically you could justify pounds 5bn to pounds 10bn, mainly on consumption. But going towards the top end of that range would have meant broken promises, in spirit if not in letter. So the great worry about this Budget was that Mr Brown would either do too little, or do enough only by imposing invisible taxes on companies and savers, letting the consumer off too lightly.

At first sight this Budget didn't quite fall into that trap. The net tax increase, excluding the windfall tax, is pounds 4bn for 1998-9, and the windfall tax raises more than is spent on welfare-to-work. Mr Brown had plenty of rhetoric in his speech about long-term fiscal stability, and the Red Book numbers should satisfy the City. He has had the courage to raise taxes and the PSBR comes down by more than the tax increases, despite the famous "black hole", because we are at the point in the cycle when (just as in 1988) extra tax revenue appears from nowhere. So the underlying fiscal balance is better than previously forecast and the Budget has made it better still.

The problem is that too much of the extra tax burden falls on the wrong target. The bad news is that the Chancellor has succumbed to the temptation, heavily trailed in leaks, to soak the pension funds. So pounds 4bn of extra revenue comes out of the pocket of long-term savers, which does little to cool the boom and reduces the pool of long-run savings available to British industry.

The situation is better than it might have been because pounds 1.6bn of this is given back to companies in the form of a reduction in corporation tax. This gave the Chancellor some good soundbites about Britain having the lowest rate of corporation tax of any of our major competitors. But the underlying reality is that pension funds, which account for the bulk of the equity invested in UK companies, face a steep increase in taxation. Given that all investment is in the end paid for out of saving, it is not clever to tax savers in order to increase the incentive to invest.

It was probably inevitable (and forecast in this newspaper) that Mr Brown would go for a package that shifts the tax burden on companies away from retained profits and on to dividend distributions. It sounds very investment- friendly to leave money in the company, rather than recycling it to shareholders. But the reality is that managers are probably less good judges of investment projects than the hard-nosed money men in the City. So although we could get more investment as a result of this change, it will be worse.

This was not such a business-friendly Budget as Mr Brown would have us believe. Nearly pounds 2.5bn of the pounds 4bn increase in tax has come out of money previously available to finance business investment. In seeking to keep faith with the electorate to whom he promised no increase in tax rates, Mr Brown has got the balance of his Budget wrong.

There were many ways he could have raised taxes without worsening incentives by putting up marginal tax rates. The personal income tax system contains two excrescences, the Married Couples Allowance and Mortgage Interest Relief. One is an outdated hangover from the tax system as it was before the introduction of independent taxation of men and women. The other was Margaret Thatcher's favourite device for turning us all into home-owners and natural Conservatives. No Conservative chancellor had the courage to abolish these barbarous relics (for fear of being accused of being anti-marriage and anti-home ownership), and we looked to a progressive New Labour chancellor to do the necessary.

Mr Brown has let us down by taking only pounds 1bn of the pounds 5bn on offer from these sources, and making up the difference by raiding the long-term saver in pension funds. He deserves half a cheer for reducing the rate of mortgage interest relief by a third, and there will be many who applaud his decision to increase stamp duty on housing transactions over pounds 250,000. Both measures will have the effect, desirable at the present point in the cycle, of cooling off the housing market, especially in the South-east.

Perhaps the most welcome aspect of the Budget speech was Mr Brown's announcement that he wanted a modern tax system based on principle, especially his decision to take time to look at possible new systems of charges to discourage polluters. Taking time is a good idea, which brings me to my final point on the first New Labour Budget.

It is a politically clever package which will be widely applauded. But at its heart is a major reform that is insufficiently thought through. Mr Brown's raid on the pension funds looks like a clever, bold stroke. But the devil is in the detail, which will come to haunt him.

The writer is a director of the consultancy London Economics.