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Analysis - Taxing times for the golden rule, by Christine Frayne

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25 March 2005

The chancellor is pledged to a surplus of revenues over current spending in any economic cycle. But with the cycle ending in 2005/06 it looks increasingly unlikely that he will be able to achieve this without tax increases

Last week's Budget was probably the last before the next general election. It is also likely to have been the last before the end of the current economic cycle, the period over which Chancellor Gordon Brown's fiscal rules - the benchmark for his management of the public finances - are assessed.

With not much room left for manoeuvre on his fiscal rules, he had little scope to deliver a giveaway pre-election Budget. Big concessions would have imperilled his hard-earned reputation for prudence. In 2001, constraints were not so tight.

Brown's 'golden rule' is met if the difference between government revenues and current spending (the current budget) is in balance or surplus over an economic cycle.

The current cycle is thought to have started in 1999/2000. At the time of the 2001 Budget, three months before the general election, the chancellor had banked an estimated £42bn to meet the golden rule. Higher tax revenues and cuts in current spending, and a healthy economy, had put the public finances in a strong position. There was much talk of an 'election war chest'.

This enabled the chancellor to give away £3.5bn. Motorists received the lion's share; income tax was cut, with a widening of the 10p band; and benefits and tax credits for families with children were increased. An important feature, in an election year, was that there were no compensatory tax increases.

The story is rather different now. The economic cycle is due to end during 2005/06 and in the December 2004 Pre-Budget Report the chancellor was forecasting a surplus on the current budget over the cycle of just £8bn. With forecasting of borrowing uncertain, there was a good chance that this surplus could become a deficit by March 2006. Revenues were also again showing slower growth than the chancellor had previously forecast. With the possibility of higher borrowing continuing next year, he was risking his reputation with every pound that he gave away last week.

In the event, he is to gain more than he is to lose as a result of the Budget. In total, he gave away £1.8bn for next year. The most significant gainers were pensioners, motorists and homeowners, who are the most likely beneficiaries of the increase in the threshold at which stamp duty on residential properties is to be paid. But additional revenues will come from corporation tax on oil companies, stamp duty on commercial property and anti-avoidance measures. Taxing business has obvious political attractions, but all business taxes are ultimately paid by individuals.

So the net effect of last week's Budget was to increase government revenues by £0.3bn. Although small, this represents a markedly different situation to that before the 2001 election. So has fiscal prudence won?

On the Budget estimates, the chancellor will meet the golden rule over the cycle with a £6bn cumulative surplus. But, using the Treasury's past forecasting errors as a guide, we estimate that he has just a 65% chance of this surplus not turning into a deficit over the next year. But this is the fourth year running that the chancellor has had to admit that his forecasts for tax revenues for the current year have been overoptimistic. If his forecasts for next year also turn out this way, the chances of missing the golden rule increase. In the Budget, the chancellor indicated that he expected tax revenues finally to improve significantly next year.

We at IFS believe that he is overestimating the revenues he will receive. If this is correct, and if next year is not the year when the much awaited improvement occurs, the chancellor might not just miss the golden rule over this cycle, but would also be less likely to be able to meet it in the next cycle on current plans.

This would necessitate tax increases to fund spending plans. But whether this is the case will only be evident after the election. Brown denies that higher taxes will be necessary, but having cut them before the last election he raised them sharply in 2002. We will not have to wait too long to see if history repeats itself.

Christine Frayne is a senior research economist at the Institute for Fiscal Studies

PFmar2005

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