Deeper cuts will restore Britain’s fiscal credibility

THIS week Fitch joined Moody’s in placing the UK’s AAA rating on negative outlook. This should send the clearest possible message to those calling for looser fiscal policy in next week’s budget.

In truth, the chancellor should tighten policy, because his reputation for fiscal credibility is already at stake. Confronted by poor economic growth last year, he did not toughen his spending plans. Instead, he moved the goalposts and postponed his target to eliminate the deficit by another two years. This is a vital budget for the chancellor to demonstrate that he will deliver on his original promise.

Fitch’s note spells it out. By delaying the deficit reduction programme, the chancellor will allow net debt to rise to 78 per cent of GDP – the “limit” for the AAA rating. Fitch will downgrade that rating if the budget delivers a “discretionary fiscal easing”, including the tax cuts for which many are lobbying. It reminds George Osborne that the Eurozone crisis “is not resolved and could once more intensify.”

Further fiscal restraint would reinforce the chancellor’s credibility. On spending, the chancellor should look again at the protected budgets of healthcare and schools. Increasing these budgets in line with the average increases across other departments over the next three years, rather than at current levels, would save £12.2bn by 2014-15. It would also promote greater innovation and efficiency. So far in this parliament, the greatest reform has been seen in those public services faced with the biggest cuts, in local government, the police and the rest of the criminal justice system. Equally the chancellor should target “middle class welfare” – that is, the £31bn spent by the government on benefits for middle and high income earners.

On tax, the budget should resist the siren calls of those urging tax cuts, whether a lower rate of VAT or temporary tax cuts on labour. The former would have little influence on the final prices of goods and services to consumers and would increase compliance costs for retailers. The latter ignores the evidence that firms tend to look through temporary reductions and only hire people they would have hired anyway. In the event of further external shocks to the economy, the chancellor may well need to raise taxes, not cut them, in which case the zero rates of VAT should be his target.

Some commentators speak as if deficit reduction has already been accomplished. In fact, the task has just begun. Of the necessary spending cuts, only one pound in twenty has been achieved so far. Sir Nicholas Macpherson, the permanent secretary to the Treasury, recently emphasised that the Treasury forecasts public spending to be even tighter in the first two years of the next parliament than in this one.

In 2010, the chancellor gained the confidence of the markets by taking tough decisions. To retain that confidence, he must deliver a budget that stays the course.

Kimberley Trewhitt is an economics and business analyst at the independent think tank Reform. Its report Reformers and Spenders is available at www.reform.co.uk.