Money Moves Markets

The Budget "Red Book" paints a dire picture of the state of the public finances. It is tempting to suggest the Chancellor has exaggerated the gloom to create room for favourable “surprises” ahead of the election but the assumptions underlying the projections look, if anything, too optimistic.

In the five months since the Pre-Budget Report, forecast net borrowing in 2010-11 has ballooned from £105 billion to £173 billion. Collapsing receipts account for £48 billion of this increase, with the remaining £20 billion due to higher expenditure.

Receipts could yet undershoot even this revised forecast. The ratio of taxes to GDP is projected to bottom at 33.0% in 2009-10 before recovering but reached a low of 31.8% after the less-severe recession of the early 1990s.

The Augustinian approach to spending discipline is maintained. Longer-term projections benefit from cuts to previous plans but the expenditure-GDP ratio surges to 48.1% in 2010-11 – the highest since 1982-83 and up from 41.0% as recently as 2007-08.

After a 3.5% drop this year, GDP is forecast to grow by 1.25% in 2010, 3.5% in 2011 and 3.25% per annum in later years. While not unreasonable, this is clearly at the optimistic end of the range of possible scenarios.

The Budget changes were modest in terms of sums dispensed. A net “injection” of £5.2 billion in 2009-10 is reversed in 2010-11 as the tax hike on higher-earners kicks in. The key measures this year are a temporary boost to capital allowances (costing £1.6 billion), phasing-in of the uprating of business rates (£700 million), employment initiatives (£890 million) and winter payments to pensioners (£600 million).

The planned hike in the income tax rate on high-earners to 50% will tie the UK with Japan at the top of the G7 league table. This will create significant negative economic incentive effects and is unlikely to raise the amounts projected, especially if capital gains tax is kept at the current 18%.

With the rise in net borrowing fully reflected in the “central government net cash requirement”, the Debt Management Office projects net gilt sales of £220 billion in 2009-10, up from £146.5 billion in 2008-09. The Bank of England, however, will absorb at least £55 billion – the gilt market's day of reckoning may be delayed until 2010-11, when a similar level of funding will need to be raised without Bank support

The macroeconomic judgement underlying the Chancellor's strategy is that higher borrowing will deliver an economic stimulus even though households and companies anticipate a significantly higher tax burden in years to come. This would be questionable in normal times but is even less likely given the unprecedented scale of necessary future fiscal adjustment bequeathed by Mr. Darling to his successor.