The immoral deficits that tax our future

Another week and it's Budget time, and the great economics and political analysis teams will swing into action to tell us whether Kenneth Clarke has fulfilled his, and their, objectives. I do not mean to dismiss these endeavours: we will after all be at it ourselves. Rather it is that to see the Budget largely in domestic political and economic terms, as we will all do, will be to miss some big themes in the global conduct of public finance. So as a prelude to the Budget, here are some of these big themes the Budget will illustrate and which are in danger of getting lost in the hubbub.

One major concern is the increasing leakage of taxation: the extent to which tax revenues are falling short of expectations. All over the world budget outcomes tend to fall short of forecasts. This happens for four main reasons.

One is that the figures are over-optimistic in the first place: the best current example of this being the forecasts of the European Commission that a large proportion of the member states will have budget deficits of 3 per cent or less. The 3 per cent figure just happens to be the Maastricht reference level for entry into the single currency.

The second is that growth disappoints, reducing tax revenues and boosting spending on social security. A third is that spending is relaxed over and above this cyclical shortfall. And the fourth is that something is going wrong with the tax system.

There is a double point here. Since 1974 taxes have tended in most countries to lag behind spending: spending has raced upwards and tax revenues have struggled to keep up. The reason for the lag was the unwillingness of politicians to increase tax rates, not a shortfall in their expected tax revenues. In the UK in the last four or five years there seems to have been more leakage than there had previously been, so much so that Treasury forecasts of revenue have consistently overestimated the amount they can rake in.

You can see the result in the first graph, which comes from a paper by Deutsche Morgan Grenfell. In 1994, the Treasury reckoned that this year it would raise just on pounds 300bn in revenues; now it looks as though revenues will be about pounds 280bn - pounds 20bn short. The trend does not seem to have been principally because of slower-than-expected growth nor wishful thinking on the part of the Treasury; more that people and companies are changing their habits in such a way as to pay less tax.

This is not necessarily the result of any illegal activity or a rise in the black economy, though of course it may be. The effect may simply be because people are working hard at finding legal loopholes, or it may even be that they are changing their spending habits to cut the tax burden.

At any rate this is not just a British phenomenon, as there are bits of evidence from other countries that tax increases fail to bring in the additional revenue that past measures achieved. I have not seen a satisfactory explanation for this, but I suspect it has something to do with concepts of the legitimacy of taxation. People have a different perception of the "right" of the state to increase taxation than they might have had 10 or more years ago, and accordingly work harder to minimise this cost. (If you say you are going to cut tax before an election and then do the reverse, you probably stoke this sense of illegitimacy.)

Go a bit further back and one more feature emerges. The UK government has been particularly vigorous at holding down the size of government. The other two graphs show the fall in public sector employment (though this is partly reclassification) since 1985, and even more interestingly, the fall in public sector investment since 1973. Note that while employment cuts were the result of Tory efforts, the sharpest fall in public sector investment took place under the 1970s Labour governments: this is not a party political issue.

Nor is it particularly solely a British issue: one of the main things driving privatisation throughout the world is the inability of the state to fund major investment projects.

This difficulty that governments are having containing their deficits is highlighted by the current efforts to meet the magic Maastricht 3 per cent. But this pretty arbitrary limit is not, in economic terms, nearly tight enough. In most cases a 3 per cent figure is not low enough to maintain deficits as a percentage of GDP, for hardly any European economies can consistently grow at 3 per cent. Managing 2 per cent has been beyond most over the past ten years. As the population of Europe and Japan (and to a lesser extent the United States) ages, these economies will be hard put to maintain even that.

Ageing leads to a further problem, which has started to attract the publicity it deserves: the unfunded pension liabilities of most continental European governments. If one were to age-adjust the deficits, the picture would be much worse. But if you suggest that countries ought not to be running deficits at all, but substantial public sector surpluses, people think you are nuts.

This is going to change. It is going to change because it has to: there really is no alternative to a long period of public sector surpluses. The trick of the last generation - to whittle away the real value of public sector debt by instituting higher- than-expected inflation - will not work again because the markets are wise to it.

Besides, ideas about the proper role of politicians are changing. The move towards a balanced budget in the States shows that there is a political tail-wind behind the idea that running a deficit is not within the right of elected representatives. In the UK, to balance the budget over the economic cycle remains the official aim of the Tories; but it is difficult to take that too seriously, given their fiscal record. We do not, however, yet regard the size of the deficits that this government has run as something immoral - a way of stealing from future generations. Breaking election promises is frowned on; running deficits which reached nearly 8 per cent of GDP is not.

It is odd, this. Governments are not companies, judged by the profit they generate, so parallels with business do not apply. A charity or a not-for-profit business, on the other hand, is expected to run a small surplus. Running too large a surplus suggests that the funds it has been given or raised are not being put to the proper purpose, and that attracts criticism. A modest and swiftly corrected slip into debit is regarded as acceptable, but only if the correcting action is taken immediately. Serious, sustained deficits are quite unacceptable, for everyone knows that the long-term objectives are being sacrificed for the short-term.

Surely this is how we should regard governments. Up to now governments have been "allowed" to run deficits because their spending is backed by their taxing power. The assumption is that in extremis they can crank more money out of the tax system to meet their liabilities. But if western European governments are at the limits of their taxing power, then that assumption falls to pieces.

We do not know what these limits are. The UK ought to have more leeway than, say, France or Italy (where the middle class marched in the streets in protest at higher taxation). But things like this shortfall in revenues suggest that there may not be much more that can be cranked out of the tax net.

You will not hear much about limits of taxation, or of the need for fairness between generations, when the Budget is discussed in 10 days' time. There will be nothing about the need to run a budget surplus, for that is not in the frame of the debate. But wait 10 years and those are the very things we will be talking about. We certainly won't be worrying about Maastricht.