16 May 2008
The public finances will be left in increasing disarray next year as a result of Chancellor Alistair Darling's May 13 decision to borrow £2.7bn to fund a tax cut for low- and middle-income households, senior economists have said.
As Bank of England governor Mervyn King warned that inflation was set to worsen markedly, economic experts said Darling would be faced with the unenviable choice of cutting spending or raising taxes in next year's Budget if fiscal rules are to be met.
They agreed that the decision to borrow – taken to compensate households set to lose out from the abolition of the 10p tax rate – just keeps the government within its self-imposed borrowing rule, but leaves the chancellor with little room for manoeuvre.
The 2008 Budget forecast that debt would peak at 39.8% of national income in 2010/11 – within a hair's breadth of the government's 40% borrowing rule. The £2.8bn represented by the remaining 0.2% has been virtually used up by Darling's decision to raise the personal allowance threshold for this year by £600, giving £120 to all basic rate taxpayers.
Martin Weale, director of the National Institute of Economic and Social Research, said that Darling was left with a narrow palette of options if he wished to get back on track next year. 'He'll be getting close to a general election, so putting up taxes in the Budget won't look terribly appealing, so I think the fiscal position will just be allowed to get worse,' Weale told Public Finance.
He added that he expected both the 40% borrowing rule and the 'golden rule' would be broken. 'It becomes harder for [Darling] to identify the pot of gold at the end of the rainbow that is going to get him out of that. His options are to cut spending or put up taxes.'
Mike Brewer, senior research economist at the independent Institute for Fiscal Studies, said: '[Darling] has technically not yet broken the rule but he has used up all the gap. If nothing changes, the Treasury will meet the net debt rule in 2010/11… [But] if there's a deterioration in the public finances they need to find extra revenue somehow, either through tax rises or reduced spending.'
He added that the higher personal allowance was likely to remain a permanent feature of the tax system.
'The problem the chancellor has is if this measure is only for one year and nothing replaces it, then not only will he get back the 4 million losers he got rid of [on May 13], but also there's the 13 million families who got a windfall of £120 a year… who might begrudge it being taken off them again,' he told PF.
'The Pre-Budget Report is likely to announce a different way of compensating the losers, but even that requires money and he doesn't have any wiggle room. I don't envy the people in the Treasury trying to come up with a package in the PBR; it all looks very difficult.'
In Darling's statement to MPs, he acknowledged that a one-off rebate or changes to the tax credit system would be costly and take time to set up, whereas increasing the tax allowance was the quickest, fairest and most efficient way of getting money to people.
'It retains the benefit of a simpler tax system and also allows basic rate taxpayers to see the benefits as soon as possible, and for the whole of this financial year,' Darling said.
'My proposal will also provide additional support for individuals and families for this year, including those on middle incomes… We are providing support at a time when they are facing additional costs.'
But the Conservatives claimed the package was a short-term political fix made by a panicking government facing defeat in the Crewe & Nantwich by-election on May 22.
Shadow chancellor George Osborne said: 'This is a panic emergency Budget from a divided, dithering and disintegrating government that has completely lost control of events.'
Liberal Democrat Treasury spokesman Vince Cable welcomed the move to lift the tax threshold, but queried how it would affect future fiscal decisions. 'If over the next two years there are regular crises in the housing market, in energy and food, what will they do? Will they simply spend more? Do more borrowing?' he asked.
After being legislated for in the Finance Bill, currently progressing through Parliament, the changes will reach basic rate taxpayers in September in the form of a £60 addition to their pay packets and an extra £10 each following month.
The Treasury also confirmed that adjustments to the tax credit system, minimum wage and winter fuel allowance, suggested as means of compensation last month, were also still being considered and could reappear in the Pre-Budget Report.