Outlook backs chancellor into a corner

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Assuming Alistair Darling does not want to use next week’s Budget to introduce large tax increases he will be in an unenviable position when he comes to the despatch box on Wednesday.

The chancellor must either predict unprecedented economic success over a sustained period; novel public spending restraint; or admit the public finances will not come under control until late in the next decade. His dramatically limited room for manoeuvre comes at a time when others have big and contradictory plans for his Budget.

Gordon Brown insisted on Thursday that the statement will be “a Budget for jobs”, while Mervyn King, the Bank of England governor, called last month for a credible plan to reduce ballooning budget deficits.

As the Financial Times revealed on Thursday, the Treasury’s starting point for the public finances is grim. Although officials think that in the short-term the economy will do better than most City forecasters expect, the outlook has not been worse since the second world war.

Public borrowing is set to reach nearly £175bn ($261bn) or about 12 per cent of national income this financial year and in 2010-11 as tax revenues plummet, the costs of unemployment and debt interest soar, and existing cash spending plans account for a much larger proportion of a reduced national income.

Public spending is poised to rise to about 48 per cent of gross domestic product, its highest level since 1982-83, compared with a forecast peak of 44 per cent in the November pre-Budget report simply because national income is likely to be lower than expected.

Although many companies might respond to such changed circumstances with immediate cuts, the Treasury has limited options in the short-term. It has already asked departments to find an additional £5bn of spending cuts for 2010-11 and further sharp reductions in already announced budgets are likely to be ruled out on political grounds.

Since ministers are almost certain to resist announcing large tax increases, the big Budget decisions for Mr Darling will be how deep the cuts to spending plans after 2011 should be, how optimistic he should be in forecasting a sustained recovery and how long the budgetary consolidation should take.

The numbers illustrate the depth of his dilemma. With a starting point of a £175bn deficit in 2010-11 and the existing public expenditure plans, nominal national income growth would have to be sustained at roughly 7 per cent for five years between April 2011 and April 2016 for borrowing, excluding capital investment, to come back to balance at the end of the next parliament.

So long as inflation is contained, that implies real economic growth of 4.25 per cent a year – a level unseen in any five-year period since the second world war.

With such unappealing arithmetic, it is likely that Mr Darling will cut spending plans, pencil in rapid growth and push out the point by which the public finances are projected to come back under control.

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