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Economics – Talk is cheap

Try as they might, the major parties will have difficulty claiming there are serious differences in their approach to macroeconomic management. Inflation targeting, Bank of England independence and a commitment to stability are common denominators across the various party manifestos.

Where the parties do offer a clear choice is on the related issues of the size of the public sector, government spending and taxation. Labour has nailed its colours firmly to the public services mast, both in terms of increased funding and greater efficiency. The Conservatives, on the other hand, have already indicated they would reduce public sector spending but believe this could be done without reducing frontline services.

As this year’s Budget report showed, the tax burden is increasing. Net taxes and social security contributions for this new tax year, at 36.3%, will rise to 38.5% in four years. In 1993-94, after years of Conservative tax cuts and fiscal reform, the proportion bottomed out at 32.8%. If the tax burden were still the same today, it would imply a tax take of about £40bn lower. To put this in context, 1p of income tax receipts is worth about £3.5bn.

At a time when the Chancellor allegedly has a ‘black hole’ in his finances, the parties’ proposals for taxation have an immediate relevance and public statements will be subject to intense scrutiny. No government raises taxes for fun, or to control the economy. The days when fiscal policy was used as a tool of macroeconomic management are long gone. Interest rates are now the weapon of choice for policymakers, which leaves taxation focusing on funding government spending, as well as achieving social objectives such as redistribution.

As well as how much money the government is spending, and what it spends the money on, the current balance between government income and spending has to be taken into account. Since giving public sector services a boost in 2000-01, the Chancellor’s tax receipts have disappointed but he filled a growing funding gap by borrowing. This reached £35.4bn in the last financial year. Since economic growth last year was a robust 3.1%, there are concerns that if the economy slows as expected, tax receipts will weaken and the shortfall will widen.

Nobody is more skilled than Chancellor Brown in putting the best possible gloss on government finances. At 3.2% of GDP, net borrowing is manageable and, with interest rates about 5%, affordable. Yet it seems the Chancellor is pushing up against his own fiscal limit – the Golden Rule. Using the original definition suggests the rule has already been breached but, with some Ronaldo-esque footwork, Brown has made some technical changes to definitions and methods of calculation to stay in the black for the rest of this Parliament.

He has, however, no room for manoeuvre. As in the past, he thinks borrowing will fall to £24bn by 2008-09, while most independent forecasters are expecting a rise. This is the so-called black hole. Since he does not recognise there is a problem, the Chancellor is not offering a solution, apart from a robust recovery in tax receipts. To maintain spending at the forecast rates, and stay within the Golden Rule, tax increases may be inevitable.

It is difficult to see what impact those advocating reform can make in the short term. Total managed expenditure by the government this year will be almost £520bn, and proposals to cut £35-£40bn may be a step in the right direction but amount to a drop in the ocean. Since the best part of 60% of the spending is on social services (including pensions), health and education, it is hard to see how frontline services can be spared from any proposed cuts and few can agree on just what the government should stop doing to save money.

If spending cannot be reduced significantly, perhaps there could be a radical look at the way the government raises its £500bn. At present, 55% comes via the Inland Revenue (income tax is 27%) while Customs and Excise duties yield a further 27% (VAT is 16%). What the balance should be between direct (income) and indirect (expenditure) taxation, and between taxes on individuals and on companies, are debates well worth having.

In the final analysis, the government is a vast enterprise, with an annual turnover of half a trillion pounds and which uses a significant proportion of the nation’s resources. Changing it is a massive undertaking that will need a lot more than a few well-chosen soundbites at election time.

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