Economics: Less taxing alternatives for Lamont

WITH luck, last week's cut in bank base rates shows that the Chancellor is aware of the dangers that still face the recovery.

Despite the tremors suffered by sterling, Norman Lamont will probably have to shave another point off before long. The pound is still a little higher than the November average, and will only be firmly supported when the markets are confident a recovery is under way and interest rates (and the returns on other UK investments) are heading upwards.

That is one of the reasons why Mr Lamont should not raise taxes in the Budget, and should not be panicked by the Government's near-failure with its pounds 2.5bn auction of bonds last week. The lack of demand had more to do with bungled tactics than fears about the deficit. Most gilts market-makers start selling bonds to clients before the day of the auction. This assures plentiful demand, and reduces the market-makers' financing costs. But Tuesday's cut in interest rates raised the price of gilts (because they pay a fixed interest rate that became more valuable to investors compared with lower-yielding cash) and thereby imposed a capital loss on market-makers.

The main lesson is that interest rate changes should be better planned and executed. The Prime Minister should not simply leap out of his bath determined to cut base rates, and the Chancellor should ensure that the Bank knows what is going on when he does. The Treasury could fund some of the borrowing requirement from the banks, and more by developing new instruments.

A rise in the overall burden of taxes would merely cut real incomes (whether by cutting post-tax incomes, or raising post-tax prices) and risk a squeeze on spending. There is, though, clearly a problem with the public finances that will need putting right before long, as the Coopers & Lybrand study commissioned by the Independent before the election pointed out. The question is when and how to put it right.

The Green budget produced by the Institute for Fiscal Studies and Goldman Sachs rightly comes out against a tax increase in March but less sensibly argues that the Chancellor should not even come clean about the need for tax rises until the second of this year's budgets in December, in case consumers start to anticipate the increase before it happens. Most British people are cleverer than most British politicians or economists think. They know that government borrowing of maybe pounds 50bn a year cannot last.

Indeed, there is an opposite danger that the uncertainty about taxes could raise unwarranted fears about tax rises. The future course of the Government's finances is especially uncertain. Despite years of intensive research effort, the scale of government borrowing even a year ahead remains subject to surprises, their principal cause being that revenue and spending are large numbers that need to change only a little to wreak havoc with the balance.

The IFS has a proud record of debunking fiscal alarmism, such as the special study conducted by the Central Policy Review Staff in 1982 for Sir Geoffrey Howe, who was always partial to some economic self-flagellation. The CPRS famously warned that the budget balance was heading for perdition, a prediction that ushered in a decade of fiscal plenty, budget surpluses and tax cuts.

The first graph gives some hint of the possible outcomes now calculated by the IFS, a range largely determined by different growth rates for the economy (and hence tax revenues). These growth paths in turn depend on the amount of spare capacity that still exists in the economy, which could be anything from Goldmans' gloomy 3 to 4 per cent to the OECD's 6 to 7 per cent. No one can be certain, because no one knows how much plant has been scrapped during the recession.

Other uncertainties include the relationship between growth and tax yields and whether the Chancellor will continue to want to balance the Budget over the cycle. There is a respectable case for arguing that the fiscal objective should be merely to stabilise debt as a proportion of GDP. On the Green budget's assumptions about growth, inflation and public spending, this might allow a deficit of 3 per cent of GDP.

The tax or spending gap to be filled would range from nothing (on the optimistic case) to pounds 20bn (or 3 to 4 per cent of GDP) on the central case and pounds 70bn on the pessimistic one.

Any chancellor is going to need a raft of new ideas and a good deal of political skill to close even a pounds 20bn gap - worth some 13 pence on the basic rate of income tax. Moreover, this figure assumes that he can meet his public spending targets, which many believe unlikely. Taxes will have to go up. In Colbert's dictum, the art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.

Since people grumble less about taxes that they can in principle avoid, a promising source of new revenue is roads. Like the EC's proposal for a carbon tax (which would plug the deficit at a stroke), road charges benefit from environmental camouflage. The motorway system could be tolled, and it would be surprising if it produced less than the pounds 2bn a year raised in France.

A tax base with even more potential is inner-city road user pricing, whereby cars would be charged (perhaps by displaying a disc), entitling them to enter the inner city at certain times. There is a respectable economic argument for such taxes because they reduce congestion. They would also have an ancillary benefit for the exchequer by allowing a gradual rundown in subsidies for public transport.

Car use is probably one of the more progressive potential tax bases. Last week's Social Trends survey shows that a third of households in this country have no access to a car, and that they are overwhelmingly the unemployed, unskilled and the old. For similar reasons, a rise in the rate of VAT is preferable to an extension of the VAT base to a large new area like fuel and light. Necessities bulk larger in the budgets of the poor: professionals spend 3 per cent on fuel while the unskilled, unoccupied and retired spend more than 6 per cent.

Another good source of revenue, as the IFS points out, is financial services. One of the fastest-growing sectors of the economy during the Eighties, finance also benefits from a curious anomaly in that it is not subject to VAT. Nigel Lawson considered, while Chancellor, imposing a consumer credit tax (which would also have applied to mortgages).

Any such tax helps to drive a wedge between the money-market interest rate, which helps to determine the value of the exchange rate, and the interest rate charged to domestic borrowers. As such, it could be a valuable new instrument to manage domestic spending power independently of the exchange rate.

The Chancellor also ought to be able to reduce mortgage tax relief, although not by more than people gain from the interest rate cuts. (For the 40 per cent of people on annual review mortgages, the cuts will come through around budget time). In the short run, the savings could fund a temporary scheme to encourage first-time buyers. As that subsidy ended once the housing market revived, the exchequer would be left with the extra revenue.

(Graphs omitted)