Treasury grips two-edged sword: Little room for manoeuvre as tax decision looms. Robert Chote reports

MICHAEL PORTILLO, the Chief Secretary to the Treasury, missed no opportunity last week to spell out the grim state of the Government's finances and to raise the spectre of further tax increases and public spending cuts.

The Treasury appears to be making rather more of an effort to massage expectations ahead of November's Budget than it did in the run-up to the last two. On both occasions, the markets were alarmed by the published forecasts for public sector borrowing, which in last year's case had already been reduced substantially from the Treasury's January internal predictions.

One reason why the Treasury may feel the need to inject a note of gloom is the unexpected strength of the recovery in the first half of the year. This has raised hopes among some City optimists that a revival in tax revenues and slower growth in social security benefits will reduce the PSBR more quickly than expected without further action on taxes and spending. Even economists at UBS, who have long argued for substantial tax increases to tackle excessive consumer spending, last week cut their forecast for the PSBR this year by pounds 3bn to pounds 46bn, accompanied by a slightly smaller reduction to their prediction for 1994/5.

Last week's Treasury Bulletin confirmed that the recovery had run ahead of expectations in the first half of the year, but was remarkably cautious about prospects for the rest of the year. It warned that personal debt remained high and that the economies of European export markets are still weak.

More surprising still, the Bulletin said it was 'still premature to state unequivocally that the peak in unemployment has passed'. It described as only 'unlikely' the prospect of the jobless total matching its 1986 peak of 3.12 million.

Mr Portillo flagged the possibility of further tax increases in November in a newspaper article on Wednesday. 'We need to reduce borrowing quickly, whereas reversing trends in public spending will take some years,' he said. 'The Chancellor may judge in November that borrowing is not being cut fast enough. Failure to reduce borrowing could lead to a permanent increase in national indebtedness which could be addressed only by permanently higher taxes.'

These warnings do not, of course, mean that thumping tax increases are a racing certainty for November. The Treasury may simply be setting us up for a pleasant surprise.

But Mr Portillo also warned that painful decisions would have to be taken if strong underlying upward pressure in several areas of government spending were to be kept in check. The implication is that success in restraining these areas of spending - or offsetting them with cuts elsewhere - is a precondition for allowing taxes to fall again ahead of the election.

Another article in the Bulletin warned that spending growth could undermine the Government's 'main objectives'. It noted that spending had accelerated unsustainably from 1988/9, with government expenditure rising by more than 3 per cent a year on top of inflation. Current pressures on spending include an expected increase of 9 per cent a year in debt interest in the next four years. The social security budget is rising at an underlying 3 per cent a year, in part as some unemployed move on to invalidity and other benefits. Growing numbers in higher education are inflating the education budget, while big capital-spending projects are bunching together.

But the Treasury's analysis did not deal with some more fundamental reasons for upward pressure on public spending. Pressure for higher government spending goes hand in hand with growth in people's incomes, as they expect the quality and quantity of publicly provided goods and services to rise in line with those they buy from the private sector. Unfortunately, in part because labour is a relatively important input, costs rise more quickly in the public than the private sector.

People also demand higher public spending because there is a less obvious link between the level of spending and the satisfaction derived from public sector services. This in turn damages morale among providers of public sector services.

The National Institute for Economic and Social Research recently noted that much of the success in controlling public spending in the early and mid 1980s had come from cuts in public sector capital spending rather than running costs. It warned that this might have to be reversed if the ageing public sector capital stock was not being replaced.

These problems all suggest that a long-term reversal of upward pressures in public spending will be very difficult to achieve. It remains to be seen how prepared our 'political Chancellor' - who no doubt aspires to be a political Prime Minister - will be to take the necessary decisions.

(Photograph omitted)