Fake blood and spending cuts

Blood has been spilt, the axeman has run amok. Yes, it's that time of year, when - if leaks of brutal cuts are to believed - the perennial struggle between the Treasury and spending departments might as well be The Whitehall Chainsaw Massacre, with William Waldegrave, the Chief Secretary to the Treasury, cast as Butcher Bill.

This year, of course, there is an overriding need to emphasise the sheer scale of the gore and carnage. The audience the Government cares about in the run-up to the Budget is not voters but the financial markets. The imperative for the spin-doctors is to soften up the City for a giveaway budget. The way to do that is to stress the ferocious nature of the spending reductions in order to justify the tax cuts that have become the Tory party's version of manifest destiny. Cuts are now said to be pounds 6bn rather than pounds 3bn off the "control total", the Treasury's key measure of public spending.

Presentation is all in this most political of budgets. Eddie George, Kenneth Clarke's former buddy (until the Chancellor roughed him up over the summer), warned after last year's Budget that tax cuts could only be justified if there was an underlying improvement in the trend rate of economic growth.

There has been scant evidence of that in the past year. Instead, what the Bank, along with everyone else, has witnessed is an unexpected worsening in the state of the public finances. So far this year, the PSBR has actually deteriorated in comparison with last.

The underlying PSBR, which excludes privatisation proceeds, has fallen by pounds 2bn, but this is less auspicious than it might seem for two reasons. The first is that privatisation revenues are forecast by the Treasury to be pounds 3.5bn less this year than they were last year. The second concerns the treatment of the privatisation of the rolling-stock companies. Remarkably, the sale of the Roscos, which raised a cool pounds l.8bn, is not treated by the Treasury as privatisation proceeds. Instead, it counts both this year and next towards the Department of Transport's budget, with the cycling baron, Sir George Young, the unlikely beneficiary.

The received wisdom about the deteriorating prospects in the PSBR is that the problem has risen essentially on the revenue side. Income tax has been running 1.6 per cent less than the June forecast of 9.4 per cent and VAT revenues have been running at little more than half the summer economic forecast of 8.6 per cent. Overall, receipts were up by 7.5 per cent in the first half of the financial year compared with the 11 per cent increase last predicted by the Treasury for the full financial year.

Lower economic growth than expected has contributed, but it cannot be the sole explanation. Consumer spending has been less than forecast, and this has meant that the Treasury has failed to garner the usual harvest in VAT revenues. The new flexible labour market, so lauded by the Treasury, has turned into a tax boomerang. The shift towards more part-time work and the low rate of earnings increase have depressed income tax revenues.

With net departmental outlays only rising in the first six months by 3 per cent - below the 3.5 per cent projected by the Treasury in June - the City consensus has been that slack expenditure control has not been the problem. Yet this view seems suspect. The Treasury's objective is for the control total to decline by almost 1 per cent in real terms this year. Yet an increase of the same order seems more likely. In any case, there is increasing doubt about the validity of the control total as an accurate gauge of public spending pressure.

The reason why the control total is likely to overshoot in real terms is that spending departments are benefiting again from unexpectedly low inflation. While retail price inflation has risen this year to almost 4 per cent, the GDP deflator, which measures "home-grown" costs, principally earnings, has been rising at only 1 per cent - considerably less than the 3.25 per cent projected by the Treasury last year.

Goldman Sachs expects it to rise by about 2 per cent in the financial year as a whole. Once again this is a consequence of the flexible labour market. The GDP deflator has risen much less than expected for the second year running.

The stage looks set for a replay of the way in which unexpectedly low inflation turned an apparently tight spending round for 1994/95 - with the control total projected to fall by 1.4 per cent in real terms - into a comfortable one, with spending rising by about that amount.

With departments able to purchase the services they are providing more cheaply than the Treasury thought would be the case, the Chancellor will not have to dip too deeply into this year's pounds 3bn reserve. Thus, he will be able to brandish cuts in public spending - the nominal cash totals - for this year and carry them forward to next year. Good for soundbites, but the picture in real terms - the only terms that matter - will be quite the reverse.

A further cause for scepticism is whether the control total is an appropriate gauge of public spending. What matters at the end of the day is total government spending. This includes debt interest and cyclically sensitive social security spending - unemployment benefit and income support. Since the control total was introduced, it has been growing considerably more slowly than the overall total, general government expenditure excluding privatis- ation proceeds.

A likely overrun of about pounds 6bn on the PSBR makes it likely that this will continue, since at gilt yields of about 8 per cent, this adds a further annual pounds 500m of interest. In addition, cyclically sensitive social security spending is proving remarkably cyclically insensitive. For example, it fell by only pounds 250m in 1994/95 despite a downturn in unemployment that on usual Treasury assumptions would have led to a reduction of pounds lbn.

None of which will stop the Chancellor from cutting taxes by whatever he thinks he can get away with, justifying the bonanza by pointing to the huge chunks of future spending that have been hacked away. The account of butchery will be precisely attuned to the needs of the City, but they should treat it, if not as The Whitehall Chainsaw Massacre, as Pulp Fiction. With capital projects certain to be axed and running costs set to be slashed, some of the blood on the floor will be real. But most will be fake.