Forecaster warns against tax cuts

PAUL WALLACE

Economics Editor

Public sector borrowing is likely to be pounds 4bn higher next year than the Treasury's own prediction, dampening hopes of Budget tax cuts, according to a leading independent forecasting group.

The Ernst & Young Item Club, which uses the Treasury's own model, suggests that the Government may not even be able to meet its own spending plans in the run-up to the next general election.

Item's forecast comes amid growing clamour from Tory MPs for tax cuts in November's Budget. John Redwood, who is challenging for the leadership of the Conservative Party, last week called for pounds 5bn savings in public sector spending to finance tax cuts, although he now appears to have conceded that tightening the public sector belt will suffice.

But the Item Club predicts that if the Government were also to cut 2p from the basic rate of tax in November, the public sector borrowing requirement would rise to pounds 24.5bn in 1996-97, almost double the Treasury's pounds 13bn forecast in last year's Budget.

In its June forecast, the Treasury raised its PSBR forecast by just pounds 3bn to pounds 16bn, a figure regarded by several City economists as wildly optimistic. Paul Droop, chief economist of the Item Club, said that, using the same model, public sector borrowing would be pounds 4bn more than the Treasury's summer economic forecast last week.

"We do not expect the Government to be able to meet its ambitious spending plans over the lead-up to a general election," he said.

"Promises of tax cuts in the immediate future, although politically expedient, may not be financially prudent given our forecast for public sector borrowing."

The outcome would be a PSBR in 1997-98 of pounds 21bn, four times the figure forecast by the Government last November, and equivalent to 2.5 per cent of gross domestic product.

The Item Club's use of the Treasury's model leads it to back the Governor of the Bank of England, Eddie George, rather than the Chancellor, Kenneth Clarke, in any future struggle over interest rates. There is speculation that the dispute over interest rates will erupt again on Wednesday when the two are expected to meet.

If the pound were to weaken further "it could prove difficult to contain price increases within the Government's stated objectives", Mr Droop said. "In this case, interest rates would have to rise towards 10 per cent during next year to respond to this threat."

Even if there was no further sterling crisis, Item does not believe that the Government's stated inflation target of 2.5 per cent or less would be achieved without a further rise in rates. In their central forecast, however, Item economists do not expect that the 4 per cent outer limit will be breached.

The main cloud on the horizon is the outlook for producer price inflation. Item expects this will accelerate to more than 5 per cent, bringing "the threat of a renewal of inflation". Retail price inflation could take off if retailers were able to rebuild their margins. This would lead to the inflationary pressure now in the pipeline being passed on to consumers.

"In order to address this risk Item feel that it would be prudent to increase interest rates to 7.25 per cent by the autumn." The advantage, they believe, is that this "could help avert the need for larger increases at a later date should inflation begin to accelerate excessively".

The Item Club is gloomier about consumer spending than the Treasury was last week. It forecasts a rise of 1.3 per cent this year and 1.7 per cent next year, as consumers continue to save heavily and to reduce indebtedness.

By contrast, the Treasury predicts that consumer expenditure will rise by 2 per cent in 1995 and 3 per cent in 1996.