KPMG: Big tax decisions to be delayed

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Few economists will escape a tingle of schadenfreude when the chancellor delivers his pre-Budget report on December 5. Gordon Brown will inevitably announce a dramatic downgrade to official forecasts for the UK economy and will probably have to acknowledge also some further slippage in the public finances.

Even when the Treasury’s projectionof 3-3.75 per cent real GDP growth in 2005 was made in March it looked somewhat ambitious against the consensus 2.5 per cent. But the extent of the slowdown has taken nearly everyone – private and public sector alike – by surprise and expectations have continued to slide. To match the latest estimate of outside economists, of only 1.75 per cent growth this year, Mr Brown would have to slash the original Budget forecast by half.

But surgery on next year’s forecast may not need to be so drastic. Most observers expect some improvement in 2006 with growth of around 2.25 per cent, not so far adrift from the Treasury’s existing 2.5-3 per cent projection. Much depends on whether the consumer will prove willing to loosen the purse strings again, or whether personal sector retrenchment, which has been mainly responsible for depressing the economy this year, continues.

Of course, what happens in the economy has an effect on the public finances. By and large, undershooting growth means a revenue shortfall. So this year’s weak activity will delay the financial improvement forecast in the Budget (although figures for the first half of the financial year seem to have held up surprisingly well, considering).

In itself, this should have no direct implications for taxes, as long as it is a question of revenue delayed, which will be made up when the economy recovers, not foregone permanently. The chancellor’s famous “golden rule”, that current spending must be met by current revenues, rather than borrowing, applies over the economic cycle as a whole – which is defined as starting and ending when output is on trend. So rather than ending this financial year as he had expected, Mr Brown could argue that disappointing growth in 2005 means we are not at the end of the cycle yet.

Backward revisions to GDP data since the Budget have already resulted in the start of the cycle being re-dated to 1997 rather than 1999. The effect is to add in a further £12bn of current surplus to the £6bn calculated in the Budget. Extending the cycle at this end would, however, have the effect of adding in future deficits.

However, obsessing about whether the golden rule will be met in this cycle risks missing the point – particularly when it is turning out to be such a movable feast. The real question is whether the public finances are sustainable going forward.

To finance current plans for health, education and other public services in coming years the chancellor is relying on an autonomous increase in revenues of two percentage points of GDP through:

- fiscal drag (a rise in the tax take when incomes are growing but the tax system is not fully indexed)

- an increased yield from financial market activity

- anti-avoidance measures

To the extent that this fails to fill the gap, the choice will be to curtail spending, borrow more – or explicitly increase tax rates.

The chancellor has already deferred the next review of spending to 2007. He probably has enough scope within his fiscal rules to delay any major decisions on taxation as well.

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