Hamish McRae: The economy will put the Blair-Brown alliance to the test

Fortunately, Gordon Brown is right in stressing the robust state of public finances

The key questions facing the Chancellor next Tuesday – aside from a rude one, "how is your next door neighbour?" – are "how bad is the downturn going to be?" and "will you have to put up taxes?".

The key questions facing the Chancellor next Tuesday – aside from a rude one, "how is your next door neighbour?" – are "how bad is the downturn going to be?" and "will you have to put up taxes?".

More of the rude one later, because there is a profound economic significance to it. First, the other two.

The pre-Budget statement next Tuesday gives us the first cut of the Treasury's new economic forecast, the building blocks for the outlook for public finances next year. Expect the Treasury to trim the growth range from 2.0 to 2.5 per cent to 1.5 to 2.0 per cent. That would bring it into line with the consensus and indeed with the new OECD forecast.

If growth turns out to be in that range it won't be at all bad by world standards, for every day that passes beings new adverse evidence: yesterday's crop included a suitably glum German Ifo survey and the European Commission cutting its growth estimates for this year and next. The financial markets, by contrast, have been extremely buoyant, looking forward to the sunlit uplands of the second half of next year, rather than the dark valley of the first half.

The most interesting aspect of the new economic forecasts for the UK will be what they tell us about the likely profile of the recovery. The big number for growth next year is less important than the timing and pace of the rebound. Better to have a slightly later but more secure return to growth, than an early bounce that then slips back into stagnation.

One of the key market indicators will be whether long-term interest rates rise. In theory higher fiscal deficits around the world ought to push long rates up; the danger is that such a rise at the long end might undermine the efforts of the various central banks to cut rates at the short end. This is not particularly a British problem, but it could become one for both the eurozone and the US.

Why not a problem for the UK? Move to the other question: will the Chancellor have to put up taxes? There is of course profound pressure not to do so for two reasons. The first is that voters might feel cheated, for though higher taxes were not explicitly ruled out during this term, they did not feature strongly in the New Labour brochure. The second is that the worst time to raise taxes is when your economy is threatened by recession and those of many of your neighbours are in one.

Fortunately both for the Government and the economy, Gordon Brown is probably right in stressing the robust state of public finances. The forecasts of Goldman Sachs are shown in the graph. Despite the slowdown in the economy, some additional funding needed on defence and worries about the future of private/public partnerships, Goldman conclude that the Government will still be well within its rules of meeting all current spending from taxation. In other words, while under the now defunct measure of the Public Spending Borrowing Requirement, the fiscal deficit would return, all borrowing would be for investment, not current spending. Indeed there would still be a modest surplus on this measure. And as you can see the net public debt would continue to decline, albeit more slowly, as a percentage of GDP.

The thing to watch for, as always, will be any projections of public spending or receipts that are outside the profile charted here. The everlasting problem of public finances is that borrowing and debt repayment form the gap between revenue and spending and if either side starts to slide away the gap can widen very fast. There may be little danger in spending rising in an unplanned way. The Treasury controls on spending are as stronger then they have been for a generation. But there is a danger, if the economic forecasts were to prove over-optimistic, that tax receipts could come in much lower than forecast, as is happening now in Germany. For the first five months of the fiscal year receipts have been running 3.6 per cent up on the previous year, against a forecast of 4.2 per cent for the year as a whole. So there is a bit of backsliding, but not much.

So short of some shock next Tuesday, expect the answer to the economy question to be "not too bad at all" and to the tax one, "no".

And now to the good neighbours in Downing Street. The story is a political and human one: how two talented, ambitious and honourable people manage a complex political and personal relationship. Such partnerships can be enormously successful: remember how Konrad Adenauer and Ludwig Erhard oversaw the rebuilding of post-war Germany. But they are tricky.

It is not just a political and economic story, though. It is also an economic one. In crude terms, the Brown camp thinks the Blair camp is in danger of making two really serious errors. One is over the euro, for early membership would be catastrophic to the UK economy; the other is over public spending, where there is a danger of throwing money at problems and achieving very little for it.

Leave the euro debate aside for the moment and focus on spending. This year spending has been running 7.2 per cent up on last year – yes, 7.2 per cent. Noticed much for that?

The core difference between Tony Blair and Mr Brown is that Mr Blair thinks that, with proper safeguards, the public sector should be able to deliver identifiable value for the additional 7 per cent that is being spent and that this will be a vote-winner. Mr Brown accepts that more money has to be spent on public services but his time at the Treasury has convinced him that spending on some projects can become a black hole into which you keep pouring money – and then get the blame for not pouring even more. So he prefers to put emphasis on tax credits to try to increase incentives to work towards the bottom end of the scale.

How will this big intellectual divide affect next year's spending round? We will catch a hint on Tuesday.