ECONOMIC ANALYSIS - On target for now, but it could cost him later.

Gordon Brown’s third Budget was a combination of New Labour and Old Labour rolled into one. New Labour was evident in the headline-grabbing measures, which ensured a positive reception. The Old Labour element was the active targeting of particular groups, particularly those on low incomes, families with children, older workers and pensioners. It was a well-targeted Budget, with credible fiscal plans; it should also give a small boost to consumer spending and still allow scope for interest rates to fall. However, it has also led to further complication in the tax system and the fiscal plans are vulnerable to growth being weaker than the Chancellor expects. This was Gordon Brown’s third Budget. In his first two Budgets in July 1997 and March 1998, the Chancellor announced a tough fiscal stance, with a number of back door tax increases. Along with tough control on public spending and an improving economy, this led to the improvement in public finances that the Chancellor is now able to enjoy. His latest Budget unveiled small tax give-aways over the next three years, although these are not big enough to make up for the tax increases announced in his previous two Budgets. The amount the Chancellor gave away also allows him to maintain fiscal policy on a sustainable path. The Budget continues the policy implemented under the Conservatives of shifting the tax burden away from income and onto spending. A new 10% tax rate was introduced and next year the 23% basic rate will fall to 22%. Although the Chancellor’s sums add up in theory, making them do so in practice depends on the economy’s performance. The track record of the Treasury’s Budget forecasts is not good. The typical one year ahead forecast error is equivalent to plus or minus £8.5bn at today’s prices. This is a huge margin of error and it highlights just how vulnerable the Budget’s sums are to the performance of the economy. For instance, if growth is 1% weaker than the Chancellor thinks, then his net borrowing could be £3.5bn higher. The political theory of the business cycle suggests that, once elected, governments should tighten fiscal policy. Then, in mid-term, policy can be relaxed, with this process continuing in the run-up to the next election. The Chancellor’s three Budgets fit in exactly with this theory. After being tough in previous years, this is the first Budget in which he has started to relax the purse strings, albeit in a modest way. Although Gordon Brown has cut a range of headline-grabbing taxes, he has also raised significant amounts by phasing out the married couples’ allowance and mortgage interest relief (Miras); and by raising taxes on stamp duty, tobacco and insurance premiums. Abolition of Miras and higher petrol taxes will have a higher negative impact on the regions, where house prices are lower and people are probably more reliant on their cars. The net result is a complicated tax system where all is not as generous as it seems. Three examples are: – The abolition of the married couples allowance is from April 2000, but the introduction of the children’s tax credit, which replaces it, is not until April 2001, leaving a year in which there is nothing. – The 10% tax rate has been introduced to help those on low incomes, but the Chancellor failed to mention in his speech the abolition of the 20% band. Thus, in the coming year, the 23% tax band is widened from £4,301-£27,100 to a new band that covers £1,501-£28,000 of taxable income. Next year the basic rate of 23% will be replaced by a 22% rate. (Traditionally the Treasury did not announce tax cuts in advance in case they could not be delivered. Apparently, this rule no longer applies.) – The new 10% starting rate of corporation tax is good, but it only applies to very small companies (profits under £50,000) and it begins to taper out above £10,000. Yet this is the price for the Chancellor’s ability to target spending on key areas, particularly people on low income and pensioners. Low income earners are more likely to spend any additional money, but in no sense will this be inflationary. Indeed, this is the time to inject money into the economy as it has slowed and is still growing well below trend. However, Gordon Brown is not keen on using fiscal policy to fine tune the economy. The Chancellor left his economic forecasts unchanged compared with his pre-Budget statement in November. Interest rate cuts since then have allowed him to do that. Yet his projection of 1% to 1.5% growth this year is on the high side and certainly requires lower interest rates if it is to be achieved. It is surprising that he did not spell out the risks to his growth projections, particularly as the Bank of England still believes there is a one in four chance of recession. The forecasts suggest that growth has only temporarily slowed and will soon return to trend. This is in line with the Bank of England’s thinking. The biggest risk is if the global economy slows sharply, but the treasury is assuming trade in the UK’s export markets will hold up well, growing 6% next year and 6.25% in 2001, compared with 5.75% this year. The Chancellor’s forecasts confirm manufacturing is in recession. Last November, he expected flat manufacturing output this year; now he expects a fall of 1% to 1.5%. As the pound is likely to remain firm as a result of the latest Budget, this will force manufacturers to keep costs under control. Inflation is expected to remain subdued, achieving the 2.5% inflation target this year and next. This economic environment reinforces the need for interest rates to fall. Even allowing for the possibility of the Budget generating a feel-good factor, there has to be a high chance of rates continuing to head lower by the summer. Dr Gerard Lyons is chief economist at Dai-Ichi Kangyo Bank (DKB) International.