Great progress on the deficit – but far too many unnecessary tax hikes

Allister Heath
WE?were told to expect a tough Budget, with lots of pain, and that was exactly what we got. Many of the policies announced were necessary; others, however, are clearly misguided. On balance, however, this Budget will leave Britain in a stronger position –?not something that could usually be said of the previous government’s efforts.

George Osborne’s courage in reducing spending is to be applauded. It is great news that public spending (on the government’s measure) is set to be cut from 47.3 per cent of GDP this year to 39.8 per cent by 2015-16. Receipts will grow from 37.2 per cent to 38.7 per cent; I would have preferred tax to remain constant and spending to fall even faster but at least we will not be enduring a crippling hike in tax as a share of national income. The national debt will peak in 2013-14 at 70 per cent and then start to drop.

The new fiscal rules – to achieve a balanced, cyclically-adjusted current budget (thus excluding capital spending and cyclical deficits) by the end of the rolling, five-year forecast period – are a little too complex. The Office for Budget Responsibility will do its best but the quantification of output gaps and structural deficits will always be deeply subjective. That said, the OBR’s new powers as an independent policeman will inject some much needed-clarity into the process. In fact, the overall macro picture is transformed – a year ago, it looked as if the national debt would be hitting 90-100 per cent of GDP. If Osborne actually delivers this fiscal tightening, a sovereign debt crisis will have been avoided. On that front, the coalition deserves very high grades.

One key point to watch: the cyclically-adjusted current balance is expected to be in surplus by 0.8 per cent of GDP in 2015-16, implying a £15bn tax cut before the next election, including hopefully the abolition of the 50 per cent top rate of tax as well as further movement on the personal allowance to take the lower-paid out of income tax. On his own figures, Osborne could have avoided raising VAT to 20 per cent, which will raise £13bn by 2014-15, and still achieved his fiscal objectives. The VAT increase was therefore unnecessary and deeply regrettable – but presumably the not-so-secret plan is to shift the UK more towards a consumption based tax system while ensuring that all of those earning £10,000 or less pay no income tax, fulfilling a core Liberal Democrat policy (and one which has long been supported by free-marketeers and Thatcherites).

In truth, most of Osborne’s cuts have turned out to be ad hoc, as have his tax increases. With one crucial possible exception, there has been no reinvention of the welfare state or of the tax system, which in many ways is a wasted opportunity. The only place where real movement is beginning to emerge is welfare: some of the cuts announced yesterday will begin to shift the culture. However, even more people will now face very high marginal deduction rates: 130,000 people will be hit by the equivalent of a 90 per cent tax rate if they go out and earn some money, thus robbing them of any incentive to quit welfare. It is vital that Iain Duncan Smith be allowed to come up with a comprehensive set of reforms to ensure that excesses are eliminated, incentives to work are restored and that the truly needed are looked after.

The move from the retail price index (RPI) to the consumer price index (CPI) for the indexation of some benefits will obviously save a lot of money. But it is short-sighted. Brown’s decision to adopt the CPI, a harmonised pan-EU measure, was one of the reasons why the Bank of England kept interest rates too low during the good years, fuelling the bubble. It is a defective and incomplete measure which doesn’t include house prices or mortgage payments, as the Tories themselves used to highlight regularly.

Following the path set by the previous government, capital spending is set to fall by 42 per cent in real terms between 2009-10 and 2014-15, accounting for two-thirds of a 7 per cent fall in total managed expenditure excluding interest. This is too much; more of the cuts should have fallen on current spending. It is also a mistake to ring-fence the NHS and foreign aid at the expense of everything else; some departments will be losing 25 per cent of their budgets even though inefficiencies remain within the NHS. This will create many problems in the years ahead.

Those who fret that the Budget could tip the economy back into a double dip recession need not worry. There is no chance of that; the reduced deficit, by keeping gilt yields lower and encouraging private sector investment, will more than compensate for any reduced consumer spending. The cuts coincide with the global cyclical recovery, which will further boost the UK economy. The OBR’s assumptions are a blow to Keynesian economists, as Henderson points out: GDP will be 0.3 per cent lower in 2014-15 than in the OBR’s pre-Budget forecast despite a two per cent of GDP reduction in the cyclically-adjusted budget balance, suggesting a tiny fiscal multiplier of 0.15. (The OBR warns its earlier forecast may have been biased up, in which case the true multiplier would be even lower.) Keynesian economics has zero relevance to our current problems. The economy will comfortably grow by 1.2 per cent this year and 2.3 per cent next year, as forecast.

A far greater issue is that Osborne’s claim that Britain is now open to business is only half-true, at best. His decision to cut corporation tax by one per cent a year from the current 28 per cent to 24 per cent, starting from April 2011, is an excellent move. True, this will be partly financed by a cut in the rate of capital allowances but the overall effect is to reduce corporate tax by over £1bn per annum so it is a real, albeit limited, supply-side tax cut (in an ideal world we would have a rock-bottom tax rate and no allowances at all). There are plenty of other good moves in the pipeline: a better tax system for intellectual property; an improved controlled foreign company regime and general simplification.

But the other changes are hardly as good, with higher earners – who tend to be mobile and the most likely to create new jobs in the UK?– continuing to be hit. The level at which the 40 and 50 per cent rates start are being frozen for three years, which means that inflationary pay rises will push hundreds of thousands of people into the higher band. Osborne’s decision to ditch the complex, costly and arbitrary restrictions on pension contributions is a good move; but his proposed cap of £30-40,000 per year means that many people will end up paying far more income tax than they previously did.

The capital gains tax changes were not as bad as feared but nevertheless represent another blow to London’s competitiveness. The top rate is now 28 per cent; there is still no indexation for inflation, which means that people will increasingly be paying tax on worthless paper hikes, which is deeply unfair. The current 18 per cent rate will remain for gains enjoyed by those on lower incomes. The tax-free allowance on the first £10,100 remains. The threshold for the special 10 per cent tax rate for entrepreneurs relief is being increased from £2m to £5m, an excellent concession.

The bank tax will further damage London’s competitiveness. It won’t be copied by our real competitors, such as Singapore or Switzerland. It will prove complex to administer. However, the news is not entirely grim for the City: the four per cent cut in corporation tax increases net profits by six per cent, including for banks, which would broadly offset the impact at Lloyds and HSBC, but still leave a negative net effect at Barclays and RBS. So the overall package is unlikely to prove disastrous for the City.
So much for Osborne’s grand plan; that was the easy bit. Now he must deliver and actually push through the cuts. The opposition will be intense; but there is no way back for the chancellor. He will either emerge triumphant – or be destroyed.