Economic View: Misuse of the PFI will cost tomorrow's taxpayer dearly

While we were being dazzled by the size of the hole in the public finances that the Chancellor revealed this week, a second, more persistent hole went almost unnoticed. The Summer Economic Forecast showed that government capital spending - already extremely low by historical and international standards - fell short even of Kenneth Clarke's meagre plans last year.

Instead of spending pounds 12.2bn on net capital investment in 1995, the public sector spent only pounds 10.6bn. And the borrowing requirement was pounds 1.6bn lower as a result. The gap persists in the future too. This year's public investment will be pounds 700m lower than planned in November. And next year's will be pounds 1.2bn lower.

Perhaps we shouldn't be surprised. When the cash gets squeezed, investment is always first to go. But this time, thanks to the cover of the Private Finance Initiative, the Treasury is getting away with bigger cuts than usual. Hoping for private investment, Mr Clarke has already cut planned public capital spending. The trouble is that the current structure of the PFI is delaying the commencement of both public and private investment projects. Moreover, while the PFI in principle could generate huge benefits, in its current form it may simply be storing up further problems for our public finances in future.

In last year's Budget, the Chancellor told us that by 1999 a total of pounds 14bn in PFI contracts would have been agreed. This was his justification for cutting public investment. As he proudly announced: "The growing importance of private finance has helped us find significant savings for the taxpayer."

In fact the PFI projects have been much slower to materialise than he promised. The Confederation of British Industry weighed in yesterday with its own list of criticisms and concerns to add to those elaborated by the Treasury Select Committee earlier this year. Inept, bureaucratic and expensive bidding processes are putting companies off for a start. And many are horrified by the amount of risk that government departments expect them to bear. A recent survey by Contract Journal suggests that up to 40 per cent of the planned pounds 14bn in PFI contracts will not have materialised by the end of the decade.

So Mr Clarke's investment cuts in anticipation of private investment may have been a little premature. Even worse. By demanding that government bodies test every capital project - no matter how inappropriate - for private funding, he is delaying planned public investment too. No wonder the public sector didn't manage to get all its investing done last year. And no wonder too that the CBI has joined the Labour Party in demanding that private finance projects be selected and prioritised, to avoid wasting everyone's time and money.

Many of these bureaucratic hitches could be resolved. But so long as the PFI is viewed as a wheeze to invest and provide services without the bill showing up on today's government balance sheet, serious problems will remain. The wheeze for the public finances and taxpayers of today risks being a burden on the public finances and taxpayers of tomorrow.

Replacing public borrowing to build public assets with private borrowing for private assets can have its advantages. So long as the hospitals, bridges, and rail links all get built in the end, we should be pleased if the private sector can find a more efficient way to do it. The trouble is that no one is really convinced, under the current design for the PFI, that it will genuinely generate long-term savings for the Exchequer, instead of being just an expensive and bureaucratic way of postponing the bills.

In the Treasury's words, the point of the PFI was that "the public sector does not contract to buy assets, it contracts to buy services". The idea is that firms retain ownership of the infrastructure they build (or at least part ownership). They then sell the services rather than the asset either directly to customers, or to the government. Firms operating new toll roads and bridges would sell swift passage to motorists. New hospitals would be rented to the doctors and nurses who made up the NHS trust.

This could be a smart move. Companies who know they have to operate the hospital building, or the IT system, or the bridge, may take a lot more care avoiding long-term design faults than companies who just hand the whole thing over to government and let them deal with future breakdowns.

In the jargon, this means sharing the risk. Under the old model, the public sector often took on the entire risk of unforeseen accidents, delays, and additional costs. As a result the new British Library is eight years late, at immense cost to the taxpayer. However, when a new computer system supplied to government under the PFI by Andersen Consulting recently broke down, Andersen had to foot the unexpected bill.

When risk-sharing provides contractors with the incentive to reduce costs and avoid problems - effectively to reduce and manage the risk of something going wrong - then the new arrangements can make savings for everyone. Michael Jack, the Financial Secretary, has claimed that projects under the PFI are currently generating savings of around 7 per cent compared with the public sector alternatives.

But there is no point in burdening private sector companies with risks that are better and more cheaply borne by government. All that happens then is that the contract - be it rent for hospitals or cash for computer services - goes up in price to compensate companies for the extra uncertainty they are taking on.

Given, too, that it is more expensive for the private sector to borrow money to invest than for the Government, you have to be pretty sure that the risks transferred do provide the incentives for a better, more efficient service, to believe that the taxpayer is still getting value for money.

Still, for many people, costly investment will still be better than no investment at all. Given that the Government is so touchy about its precious public sector borrowing requirement and the search for tax cuts, few have much hope in extra funds for capital investment in the near future. If the private sector have got the money to do it, why not let them?

In some cases, where the repayment on the private money comes from user charges such as tolls, this is a good argument. The toll-payers may be forking out more each time they cross the bridge than if the Government had paid for it, but at least they have a bridge to cross now. They may even prefer paying more in tolls and less in taxes .

But many of these services are not sold directly to individual customers, they are sold to the state. NHS trusts pay the rent for their new wing - on behalf of the Department of Health and ultimately the taxpayer. Capital investment that appears on the PSBR today is being replaced by current charges on the government balance sheet tomorrow. And if those charges are higher than they would have been if the government just carried out the investment itself, then tomorrow's taxpayer is getting a raw deal.

As Labour's shadow chief secretary, Andrew Smith, argued in a speech to the Public Private Partnerships Programme earlier this week: "It is a mistake to think that private finance can in some way circumvent macro- economic constraints on public investment."

This, then, is the test for the Private Finance Initiative. While it is a means to draw on the skills and experience of the private sector to do exactly what it does best, the PFI could be an extremely valuable addition to public sector management. Once it becomes a way to push capital spending off the government balance sheet, to reduce government borrowing today, then the taxpayers of tomorrow are in trouble.