Economic Commentary: Why a tax increase is inevitable

The debate on economic policy continues to be dominated by the recession, and how to end it. This is a thorny topic, but not half as thorny as the big question dominating the intellectual debate inside the Treasury: how much the Government will need to raise taxes, and when the announcement should be made.

The Tory line during the 1992 election campaign was that the Government's medium-term public expenditure commitments could be achieved without raising taxes, and while simultaneously balancing the Budget by the end of the Parliament. The Chancellor, Norman Lamont, has since admitted that the Treasury forecast on which these claims were based was 'massaged' by ministers before publication, and the projections certainly seemed optimistic to most economists at the time.

Indeed, Andrew Dilnot, of the Institute for Fiscal Studies, became something of a celebrity during the campaign by having the courage to point out that the Government's arithmetic, as well as the Opposition's, was singularly rose- tinted. For his pains, he received much abuse from the politicians, who it would be nice, though excessively naive, to think now feel suitably chastened. But not even Mr Dilnot knew at the time how quickly things would deteriorate in the first few months of the new Parliament.

The diagram shows just how wrong the 1992 Budget projections have already proven to be. Undoubtedly, the main reason has been the unexpected prolongation of the recession into 1992. In fact, gross domestic product this year will

be a full 3 per cent lower than the Treasury expected at Budget time, and this shortfall in growth comfortably explains the pounds 9bn increase in government borrowing since the Budget.

What is much more worrying is that it is becoming increasingly difficult to support the Treasury's optimism about GDP growth over the next few years. In its pre- election plans, it assumed growth would average about 3.5 per cent a year from 1993-1997, arguing that a period of above-trend growth would inevitably occur as the economy absorbed the vast amount of slack created during the recession. Because of this slack, a period of high GDP growth, the Treasury said, would be consistent with a subdued medium-term inflation rate.

Productive capacity

In effect, the Treasury was expecting a re-run of the early and mid-1980s, when GDP growth was above 3 per cent for several successive years, and inflation stayed low. But two things have happened this year that make a re-run of this experience seem less likely. The first is that the longevity of the recession may well have started to erode the productive capacity of the economy as factories get scrapped and the long-term unemployed lose their motivation to return to work. In essence, the capacity of the economy

may get dragged down to match the subdued level of output during the recession. There is, accordingly, less room to expand output in the medium term without hitting capacity constraints.

This then links into the second problem, the chronic trade deficit. By far the most sobering development in the economy this year has been the fact that the current account deficit will be twice as large as the Treasury expected at Budget time ( pounds 6bn), despite the fact that GDP will be 3 per cent lower than forecast. This is a truly formidable worsening in Britain's underlying trade performance, compared with what had appeared likely a few months ago, and it must have serious implications for the sustainability of any recovery based on domestic demand.

This is the basic reason the economy cannot simply replicate the recovery phase of the 1980s. During that recovery, the balance of payments position worsened by no less than 7 per cent of GDP - from a surplus of 3 per cent in 1981 to a deficit of 4 per cent in 1988. Because the starting position was so strong in 1981 (thanks to oil), a massive deterioration in

the trade account was just about permissible during the economic upswing. This time, the starting position for the trade account is about 5 per cent of GDP ( pounds 30bn) worse than it was in the early 1980s, which means the consumer-led recovery of the last decade cannot be repeated. Admittedly, there are one or two extenuating circumstances for the abysmal trade figures. If we examine the trade position in other countries, we find that most of them appear to be running significant deficits. The reason is two- fold. First, there is a global data error or 'statistical discrepancy' of about dollars 100bn. Second, there is the endemic Japanese trade surplus, which could also soon rise to dollars 100bn. Britain's pro rata 'share' of these items is worth about pounds 9bn,

which explains most of the present deficit. Yet this still leaves us with severe medium-term problems. Only once in the past 30 years has the UK managed to generate an export-led recovery in output, during which the balance of payments position actually improved.

Exchange rate

This was in the much-maligned period from 1976-79, when the exchange rate was extraordinarily competitive (about 15 per cent more so than now), and when the IMF was imposing an extremely tight budgetary straitjacket on the Labour government. In all other recovery phases since the Second World War, the balance of payments has worsened markedly. This cannot happen this time.

The Government therefore has two choices. The first is to accept that the recovery will be very slow, proceeding at a pace that leaves the trade account unchanged at current exchange rates. The trouble with this strategy, though, is that the growth rate in GDP would probably need to be held to about 1.5 per cent a year, in which case unemployment would continue to rise and government borrowing would be running at about pounds 70bn a year by the mid-1990s. Sooner or later, this would probably create a massive financial crisis of 1970s proportions.

The second alternative is to attempt to

head off this looming financial crisis by changing the mix of policy well in advance. Although it is hard to be confident about the scale of the policy change required, the direction is clear enough. Monetary policy must be kept easy to allow the exchange rate to remain competitive. Meanwhile, budgetary policy must be tightened considerably to retard domestic demand, and to control government borrowing.

And that tightening in budgetary policy will almost certainly need to come through higher taxes. As the graph shows, the share of public spending in GDP is considerably below the peaks reached in the last two recessions in 1975 and 1981. The tax burden, on the other hand, is about 8 percentage points below the 1981 level, and 5 points below the 1975 level. Viewed in this light, the tax reductions introduced by Nigel Lawson in the late 1980s - based on the false assumption that a trend improvement had taken place in GDP growth - look increasingly flawed.

Two Labour Chancellors, Roy Jenkins and Denis Healey, have been forced into a position where devaluation had to be combined with the abandonment of their governments' most cherished objective, the improvement of the public services. The Conservative Chancellor of 1993-95 will similarly be forced to combine devaluation with the abandonment of his government's first imperative - this time, a reduction in taxation.

The only questions are which taxes will increase, and whether the Government will have the foresight to raise them before a financial crisis forces a change in calamitous circumstances for the economy.