Economics: Tax increase can ensure growth later

A Chancellor is never short of siren voices enticing him to wreck his policy on the nearest available rocks. The sharp-eared will already detect wailing from the backbenches and even the City suggesting that Kenneth Clarke may not need a tough Budget in November after all. The figures are improving, Old Boy. The recovery will bring the deficit down. Don't rock the boat.

Despite some people who find encouragement in last week's figures for July's Public Sector Borrowing Requirement, there is no real evidence that the public finances are yet better than expected in the Budget. Just four months of a financial year is a flimsy basis for an argument, especially when the deficit is the volatile difference between two much larger numbers.

Even taking the data at face value fails to shift the Government's forecast of a pounds 55.5bn deficit (excluding privatisation receipts). The cumulative deficit so far this year is pounds 8.2 bn, which is 32.8 per cent of the forecast. The cumulative deficit at the same point last year was pounds 14.8bn - precisely 33 per cent of the pounds 44.8bn outturn for 1992-3.

The real reason for supposing that the deficit will be lower is that growth forecasts have been edging up since the Budget forecast, and the summer forecast given to ministers and senior staff at their two days of pre-Budget 'think-in' at Dorneywood last month was no exception. But the big improvement, if the more optimistic forecast is sustained, will come next year because of the one-year time lag in the collection of self-employed income tax and corporation tax.

However, it is the most elementary mistake to set fiscal policy - decisions about public spending and taxation - on the basis of what is happening to the crude deficit. The deficit inevitably rises during a recession, as tax revenues drop and the spending on unemployment rises. The deficit promptly falls again when the recovery throws those trends into reverse. A natural rise in recession should not be offset by tax increases that would merely drive down spending power further and worsen the recession. Nor should a natural fall in the deficit become the excuse for Lawsonian, boom-stoking fiscal laxity.

Politicians are usually rather good at understanding the easy first part of the message. The Government did indeed use its discretion not merely to allow the deficit to rise naturally during the recession but to raise public spending and cut taxes. So part of the turnaround from surplus to deficit was due to policy changes.

We are not talking small numbers. The intergovernmental forecasting club, the Organisation for Economic Co-operation and Development, calculates that Government policy decisions pumped in spending power worth 3.3 per cent of the national economy - about pounds 20bn - in 1992 and 1993. The recession would have been far worse without this stimulus.

Sadly, politicians are altogether less willing to implement the other part of the Keynesian message, which is that the underlying deficit should be reined back in a recovery.

True, Norman Lamont put forward tax increases worth 1.5 per cent of the national economy which will take effect next spring and the year after. But these decisions will offset less than half the total relaxation during the recession.

Most sensible analysis now suggests that the Chancellor needs to go further. If he does not, we may lose the option of using fiscal policy to cushion the next downturn.

Of course, it is possible to argue that the long-term Budget position is not as bad as many fear. If there is a lot of spare capacity in the economy, then it will be able to grow strongly for several years without demand running ahead of supply and reigniting inflation. Even if there is not a lot of spare capacity, industry may be more nimble in its investments as demand rises, so that high growth could be more sustainable. And if the economy now grows very strongly for many years, the deficit may shrink anyway.

It would be wonderful if this story were true, but there is great uncertainty about some of the key calculations. The latest Bank of England inflation report, for example, showed that the current estimates of the spare capacity in the economy range from 2 to 7 per cent. If spare capacity is 2 per cent, we would be back at full capacity after just two years of growth at 3.5 per cent. The deficit would stay high. If spare capacity is 7 per cent, we could grow by 4.5 per cent a year for more than three years, and the deficit would wither.

It is too early to be sure that the economy will emerge from this recession able to grow at very rapid rates. There are encouraging signs, notably the performance of the car industry. But we are still very poorly educated and trained. And our balance of payments problem represents a potentially serious obstacle. It makes sense to base fiscal plans on a more circumspect view of our growth prospects.

There are several other arguments that should persuade the Chancellor, having failed to make more convincing cuts in public spending, to raise taxes. The first is simply that the risks are stacked heavily in favour of doing so. If the Chancellor finds the deficit disappearing far more rapidly than he expected, he will have the happy task of cutting taxes.

If, though, the economy grows more slowly, an unexpectedly large deficit could lead to a sharp fall in government bonds and in the pound, forcing a rise in interest rates and a halt in growth. In short, the downside is far worse than the upside. It is rational to insure against catastrophe, even if the risk is a small one.

If I had any remaining doubts about the sustainability of the recovery, I would argue that the Chancellor should await further evidence before taking purchasing power out of consumers' pockets. But the recovery is now well entrenched. Moreover, it will become progressively more difficult to take tough economic decisions as the next General Election approaches.

If the recovery is to be sustainable, it must be led by exports and investment. Consumers' spending must grow more slowly than output if we are to send more exports overseas and hold down the trade deficit. Tax increases - whether on incomes or spending - will keep the recovery on course.

(Graphs omitted)