Economics: Tax rises vital to long-term health

THE greatest threat to Britain's fragile economic recovery is not that last week's tax increases will persuade consumers to spend less, but rather that consumers will ignore them and spend more.

Fifteen years of free-market reforms and irresponsible tax-cutting have served only to exacerbate the structural deficiencies at the heart of the economy: we consume and import too much, but invest and export too little.

The tax increases announced by Norman Lamont and Kenneth Clarke last year - the latest tranche of which came into effect last week - are an uncomfortable but necessary step to repair the damage inflicted by their predecessors. Modest downward pressure on consumer spending is not a problem, rather an unavoidable part of the solution. In fact, the Lamont and Clarke Budgets may eventually prove to have erred on the side of timidity.

Consumer spending is not intrinsically undesirable; indeed, it is the ultimate objective of economic activity. But consuming too high a proportion of our national income at any one time imperils our ability to consume in the future. Personal consumption currently accounts for an unprecedented three-quarters of national income, and almost all the rise in spending since the economy slipped unnoticed past its trough in the spring of 1992 has been down to the consumer.

But without adequate investment, the economy will lack the capacity to produce goods and services to satisfy rising demand without running into inflationary bottlenecks. Similarly, if imports run too far ahead of exports, the trade gap will widen and international investors will demand ever higher interest rates to fund the deficit with capital inflows. Whether nemesis awaits in the form of accelerating inflation or a balance of payments crisis is a moot point - both are symptoms of the same underlying structural malaise.

The package of tax increases assembled by Messrs Lamont and Clarke confiscates the bulk of the money doled out in the tax cuts of the late 1980s, justified at the time by an erroneous belief that the economy had undergone a beneficial structural transformation during Margaret Thatcher's first two administrations. The Institute for Fiscal Studies calculates that the Lamont/Clarke Budgets will recoup four-fifths of the pounds 25bn that Nigel Lawson gave away.

This process will leave the tax system looking rather different from the way it did in the mid- 1980s. Most importantly, the tax cuts were skewed in favour of the rich, but the tax increases have been spread more widely over the entire population. As the poor are inclined to spend a higher proportion of their income than the rich, this should have some beneficial effect in reducing the economy's aggregate propensity to consume. But this will be at the price of a further worsening in inequality and a greater tendency to spend on imported goods.

It is a damning comment on the achievements of 200 years of economic theorising that we have very little idea how consumers react to rises and falls in taxes. Will the tax increases come as a sudden shock and bring high-street spending to a shuddering halt? Or will consumers have shrewdly realised that Mr Lawson's generosity could only have been temporary and that the tax rises that followed were inevitable? In that event they may already have taken them into account in planning spending.

The chances are that consumers do not have that foresight, so high-street spending should be slower than it otherwise would have been. Last Thursday's industrial production figures even showed some evidence that this rebalancing may have begun, revealing that production of investment goods rose three times more rapidly in the three months to February than output of consumer goods - reversing the pattern earlier in the recovery.

Retail sales growth and consumer credit have also weakened slightly in recent months, while consumers' confidence in their own financial circumstances has dropped well below any level seen since the end of the recession, according to Gallup's monthly polls. Nonetheless, it is still more likely that this recovery will end in inflation and an unsustainable widening of the trade gap than that it will be stopped dead in its tracks by consumer retrenchment.

Taxes on consumers are being raised by about pounds 15bn, or 2.5 per cent of national income, over the next two years, a greater hit than that imposed by Geoffrey Howe in his infamous Budget of 1981. But this is not being imposed in one fell swoop, which will help to limit the shock.

Excise duty rises have already been imposed, with further increases above the rate of inflation also guaranteed. VAT on fuel bills is being imposed in two stages, this year and next but will only be paid as quarterly bills arrive. The rise in national insurance contributions will bite steadily with each monthly pay packet, while the freezing of income-tax allowances cuts only the real value of wages and salaries, leaving their cash value untouched. Cuts in mortgage tax relief take effect with each monthly payment and will not be imposed fully for another year. The freeze on public-sector pay bills can also be seen as a de facto tax increase imposed on the long-suffering workers in that sector.

Offsetting these effects is the lingering influence of the 9.75 percentage point cut in interest rates seen since 1990, taking base rates from 15 to 5.25 per cent. This should not be underestimated.

Darren Winder, a former Bank of England economist now with Warburg Securities, calculates that someone on average earnings who took out a pounds 50,000 variable rate mortgage in 1988 would have seen their post-tax, post-mortgage income fall by 27 per cent in real terms by mid-1990, only for it to rise by 78 per cent between then and the end of 1993. The resilience of income growth for people who stayed in work throughout the recession will continue to give consumer spending momentum.

People in work are also now in a better position to compensate for tax increases by pushing up their pay. Private sector pay settlements have risen from an average of around 2 per cent in December last year to about 3 per cent in March, judging from the surveys by Incomes Data Services. Wage bargainers are already trying to compensate for the recent uptick in headline inflation, emboldened by the fact that falling unemployment and net job creation - albeit largely part-time jobs for women - has given them greater labour market power.

The gentle recovery in the housing market should also help to keep spending on track. The number of houses bought and sold has been rising for months, with house prices already increasing at an annual rate of nearly 4 per cent, according to the Halifax. This has sprung half a million mortgage holders from the trap of negative equity, with every 1 per cent rise in house prices in the South-east alone releasing another 70,000.

The falling cost of servicing mortgage debt suggests that the stock of debt as a proportion of income, still at levels unprecedented until the 1990s, may not be an insuperable barrier to further falls in the savings ratio, the proportion of income saved. The depressing effect of the tax increases on consumer spending will ultimately depend on the extent to which it is offset by falls in the savings ratio, which in turn depends on consumers' willingness to borrow.

The savings ratio has already fallen from well over 12 per cent in 1992 to 10.2 per cent at the end of last year, encouraged by low inflation, cuts in interest rates, falling unemployment and falls in the number of business failures. There is no reason for it not to drop further as it did after taxes were raised in the early 1980s, although at that time the process was given an extra shove by the liberalisation of credit regulations.

Mr Clarke will be keeping a close eye on consumers' behaviour in the next few months, but unfortunately it will be a good while before we or they can be confident of the trend that emerges.

Ideally, interest rates would already be lower than they are now and last year's Budgets would have been tighter. But that opportunity has been missed. There is little case now for another cut in rates to prevent recovery from

collapsing, and the day when they have to rise again is drawing ever closer

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