Hamish McRae: Cut taxes, but don't expect miracles

The Government can pull all the levers, but there's nothing at the other end

There is nothing wrong with tax cuts but don't expect them to give a massive boost to the economy. We have had the Opposition's intentions yesterday and we will get the Government's actual cuts later this month in the pre-Budget report. But the numbers are such that it is hard to see tax cuts having more than a marginal effect. The Government can pull the levers but there is nothing attached at the other end.

Let's say that taxes are cut by an extra £15bn, the upper limit of suggestions put about by the Government. Sounds a lot, doesn't it? In one sense it is because that would be equivalent to 1 per cent of GDP. But the Government will borrow something around £50bn this financial year and there are projections of the deficit rising to £80bn or more in the next financial year, the one that starts next April. We don't know how the extra tax cuts might be phased, but the harsh truth is that if borrowing £50bn or £80bn won't boost the economy, why should £65bn or £95bn?

The same logic applies to the Tory idea of cutting employers' national insurance contributions. Certainly NICs are a tax on jobs and that does not make much sense in a recession, but the idea that a prospective employer will take someone on just because the NICs are cut presumes that they were thinking of taking more people on in the first place. They still have to pay the wages; they still have to be assured of demand for their products; and they still have to have banks that will lend them more working capital. Yes, it may help at the margin but the idea that it would make a material difference is for the birds.

The world has a lot of experience of the effect of fiscal and monetary boosts, and that experience is not encouraging. Japan gave a huge boost to its economy in the 1990s, driving interest rates down to zero and running a fiscal deficit that ran at 8 per cent of GDP. It didn't work. This year the US has given a big boost to the economy and demand did perk up in the summer. But now the country is heading into recession, along with everyone else, with most forecasts suggesting it may have the second-worst downturn – second that is to the UK.

We will get more of a feeling for the scale of the problem today with the new Bank of England forecasts for the economy in its Inflation Report. These will show the expected scale of the downturn next year and the expected path back towards growth presumably in 2010. The Treasury will produce its own forecast on which its tax and spending plans will be based with the PBR. But having produced an absurd forecast for growth next year in the Budget – one so ridiculous they should be really ashamed of it – this time it will have to be broadly consistent with the Bank's one. Just to remind you, in March the Treasury was forecasting growth in 2009 to be between 2.25 and 2.75 per cent. They didn't even get the sign right, let alone the big number.

If this sounds like a doctrine of despair it need not be. There are things that can be done to both to reduce the scale of the downturn and to help buffer the most vulnerable from its effects. Some are happening already. The easing of monetary policy is one and it has been eased to two ways.

One is obvious; the cuts in interest rates. Sure, those are not being passed through fully, partly because money market rates have remained so high. But these are coming down a bit and now that the banks are being re-capitalised the flow of new mortgages and business credit should start to recover. Banks make profits by lending money; the trouble has been that they have not had the money to lend. Gradually, if achingly slowly, that is being fixed.

The less obvious way that monetary policy is being eased is by the fall in the pound. The Bank of England used to have a rule-of-thumb that a four point fall in the exchange rate was equivalent to a one point fall in base rates. We have had a fall in sterling of around 20 per cent, so on that basis it would be equivalent to a cut in base rates of 5 per cent. We would be being paid to borrow.

Unfortunately things are not quite as simple as that and the transmission mechanism, through greater demand for exports and less demand for imports, is an indirect one. But for exporters the fall in the exchange rate is hugely helpful and I am told that UK service industries that cater for foreigners are doing well too. The trick now will be to make sure that fiscal policy supports monetary policy rather than working against it. That will be the task for the Chancellor in his pre-Budget report. Three things need to happen.

One is that the natural stabilising effect of fiscal policy in recessions needs to be allowed to work. Tax revenues will fall. It is quite plausible that come the spring, revenues will be running lower than they were a year earlier. Meanwhile current spending, on for example welfare benefits, will rise. You allow that to happen; you don't panic; and you make it clear that as growth resumes and revenues recover they will use them to cover the extra deficits accumulated in the bad times.

Two is that you make sure that taxation is not making things worse. For example the Revenue has been caning small businesses recently, trying get them to pay tax earlier, and being generally more aggressive. It has done this because tax revenues have been falling short and it has been under tremendous pressure from the Treasury to try to get more money in.

The effect – aside from upsetting small businesses and encouraging large ones to move offshore – has been to discourage investment, which is falling. There is a huge case for looking at the detail of taxation, seeing where it can be simplified, and seeing where it has actively discouraged investment and employment. The Tory plan touches part of this but what is needed is a detailed approach by people running the show, not a broad-brush one from political opponents.

And the third thing is that the country desperately needs something to replace the busted fiscal rules. The Government, and here I blame Gordon Brown, has done exactly what it sought to avoid: it failed to even out the cycle because it over-spent in the good years. What they do is less important than the fact that they do something, because presumably it will all be changed in another 18 months. But that is another story for another day. First thing is to stop fiscal policy from undermining monetary policy and tax cuts will have their part to play in that.