Brown's bills raise spectre of tax rises

Government finances plunge into the red as departments re-learn how to spend

Tax on home sales! A levy on children's cycle helmets! VAT at 20 per cent! The hysteria over possible new tax measures is matched only by the depth of the gloom surrounding the state of the national finances. Red is quite definitely the colour of the Government's bank account statements as well as its political party logo.

After the early years of the Labour administration when Gordon Brown was able to announce even larger surpluses than he had forecast, that benign position has been turned on its head. Now analysts believe he will miss his forecasts for modest and declining deficits over the next five years.

The Government borrowed another £2.8bn last month, taking its deficit this year to £22.5bn and within sight of the £27bn that just six months ago it believed would cover the whole year. A simple extrapolation suggests public borrowing will breach £40bn if the second half follows the pattern of the first.

Most analysts believe the deficit will overshoot by a similar margin next year, when the Government forecasts it will fall to £24bn. The simple reason is that spending is racing ahead of the Government's forecasts while the growth in tax receipts has proved disappointing. After years of failing to spend its full allocation, Whitehall has finally remembered the old habits of spending that it kicked during the dark Thatcherite days of the 1980s.

Spending is running at an annualised rate of more than 11 per cent, compared with a Budget forecast of about 7 per cent. Meanwhile a slump in corporation tax revenues, thanks to weak business profits, means receipts are growing by less than 6 per cent a year compared with a Budget target of 7 per cent - less dramatic but a shortfall nonetheless.

But does it actually matter? All major industrialised countries are racking up debts to fund government spending at a time when the global recession has sapped the willingness of the private sector to spend - deficit financing in Keynesian economics. The Treasury points out that at 3 per cent of GDP today's deficits are nothing compared with the 8 per cent hit in 1994 under John Major. "We have the lowest [total net] debt of the G7," said a spokesman.

Ironically, critics of the UK's rising deficit are even more condemnatory of Europe's stability and growth pact that attempts to prevent countries borrowing more than 3 per cent of their annual GDP. But the UK has its own system of fiscal discipline - invented by the Chancellor himself - and it is against this test that the public finances will be measured.

The financial markets do not like large deficits and tend to punish them by raising long-term interest rates - which feed through to mortgage rates - and dumping the currency, which can boost inflation.

Mr Brown's "golden rule" dictates that, averaged over the economic cycle, the Government must keep the public finances in surplus. Since the Treasury says the current cycle began in 1999 it is able to include receipts from the sale of third-generation (3G) mobile phone licences that raised more than £20bn.

This has left the Government with a sizeable accrued surplus that can be used to offset deficits until the cycle is deemed to have ended. A spokesman for the Treasury said: "We are clearly going to hit the fiscal rules. I would be surprised if we produced a pre-Budget report that has us doing anything other than that."

On that, independent analysts agree - even if only for the reason that it is the Government that deems when the economic cycle begins and ends. David Page, the UK economist at Investec Bank, said: "It would take a substantial deterioration of the finances, even from here, to threaten the fiscal rules over this economic cycle.However, the next economic cycle, which will not have the benefit of substantial [3G] auction receipts, could start with high levels of public borrowing."

Given his reputation for prudence, Mr Brown would be under pressure to take action to offset the mounting deficits - unless he were prepared to wait for the return of surpluses towards the end of the next cycle. He has three clear options - cut spending, raise taxes or break his rules and borrow whatever is required to pay for the Government's high profile spending plans. Given the sorry electoral record of governments that let deficits run out of control, Labour would be unwilling to be seen to fail its own tests.

In terms of spending, Mr Brown has said he wants departments to stick to their spending limits. The Treasury said the rate of spending growth was slowing, implying expenditure had been "front-loaded". Mr Brown is also keen to cut waste in public service provision. Yesterday the Treasury published details of a review announced in the Budget and aimed at increasing efficiency in the state sector. However, this pales into insignificance compared with the figures involved in next year's three-year spending review.

The Government has already committed to real increases in NHS spending of 7.4 per cent a year between 2006 and 2007. Ed Balls, Mr Brown's chief economic adviser, has indicated non-NHS spending will continue to rise in real terms. According to PricewaterhouseCoopers, if education spending growth rises 3 per cent a year, while other spending is capped at 1.5 per cent, the cyclically adjusted budget will be into the red by 0.8 per cent of GDP by 2008.

This is where the debate about tax becomes a reality. PwC estimates this would require a tax increase of up to £15bn - equivalent to 5p on the basic rate of income tax. Investec's Mr Page said: "We take the view that with the general election possibly only 18 months away, the Chancellor will be as keen to avoid more unpopular tax rises on the voting public as he will be to cut politically sensitive public spending programmes. But beyond the next election, we believe it would take a substantial recovery in the finances to avoid a significant curtailed spending programme and/or additional hikes in household taxation."

One Sunday newspaper said the Government was considering imposing capital gains tax on house sale profits - an act of political suicide that was swiftly denied by the Government. As The Economist magazine said recently: "An Englishman's home is his tax haven."

BDO Stoy Hayward, the accountants, warned that VAT will rise from 17.5 to 20 per cent by this time next year, which would raise £9.5bn a year. Stephen Herring, a tax partner at the firm, said the Government could say it was responding to pressure to harmonise VAT rates across Europe."An increase of [up to] 2.5 per cent is certainly not pie in the sky and we predict that by autumn 2004 the Chancellor will have done just this if tax revenues remain weak," he said. He added that items such as children's clothes and cycle helmets attract no VAT, when they are charged at almost 20 per cent in France.

If tax rises are in the pipeline they are likely to come in stealthier ways. Odds are shortening on another rise in national insurance. Only yesterday the CBI was complaining about a little-noticed change to stamp duty on corporate leases that could raise the tax bill eight-fold. As the Duke of Edinburgh is reputed to have said: "All money nowadays seems to be produced with a natural homing instinct for the Treasury."