Britain has sunk itself deep into a fiscal black hole

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In practice, the only successful method of reducing public spending as a share of GDP has been to impose tight curbs while the economy is growing rapidly. We shall be lucky if such an opportunity appears.

This year, Britain is likely to incur a fiscal deficit of more than 12 per cent of national income. This figure is completely outside the normal experience of developed countries in peacetime. How did it happen and what are its implications?

The normal rule of prudent public finance is to allow for substantial cyclical variation. Recessions cut tax receipts and lead to additional expenditure, especially on benefits. Moderate surpluses in good times turn into moderate deficits in bad times, so things balance out overall.

The British government, ostensibly committed to this principle, has obfuscated to abuse it so that Britain entered the recession with a large underlying deficit. The downturn turned a substantial gap in public finances into a chasm. This situation was aggravated by the speed and scale of the recession and the realisation that many of the earnings from financial services, which had previously boosted tax receipts, had been illusory. The contribution of financial services to public finances has been not only removed but reversed.

Even if there were a rapid economic recovery, there would still be a large deficit. At least half of the current deficit will need to be eliminated by cuts in public expenditure and increases in tax rates. These will have to be very substantial. After all, 1 per cent of gross domestic product equates to 3 per cent of public expenditure, two points on the basic rate of income tax and three points on the standard rate of value added tax. At least six such “units” of deficit budgeting will be required over the next few years.

And the background is not benign. There are always upward pressures on public spending, but there are several additional ones ahead. The costs of servicing public debt will rise, as amounts and rates increase. The government will, like the banks themselves, defer accounting for the costs of the bank bail-outs as long as possible. But the reality remains that every penny that subsidises the financial system is a penny diverted from schools and hospitals.

The costs of off-balance-sheet financing have also come home to roost, as they always do. The spending of local authorities and National Health Service trusts will be squeezed by commitments they have incurred under the private finance initiative. The impact on health and benefit costs of an ageing population will begin to make itself felt over the next decade.

In practice, the only successful method of reducing public spending as a share of GDP has been to impose tight curbs while the economy is growing rapidly. We shall be lucky if such an opportunity appears. The reality is that the usual victims of pressure on discretionary expenditure – nurseries and universities, culture and sport – should brace themselves for hard times, and Britain’s crumbling public infrastructure will crumble further.

Inflation reduces the value of public and private debts and makes many adjustments easier. It is much easier to fail to keep wages and salaries in line with inflation than to reduce them outright. It would be a pity to throw away the gains from a successful struggle over two decades to squeeze inflation from western economies. But the governments of Britain and the US may separately and privately conclude that such a choice is less bad than the other options they face.

Even so, both countries are going to have to reconcile themselves to substantially higher tax rates. A tax package to raise £70bn ($115bn, €82bn), probably the minimum required to stabilise Britain’s public finances, might put four points on the rate of income tax, take VAT to 20 per cent, freeze personal allowances and tax thresholds, add five points to corporation tax and collect a bit of extra revenue from the usual suspects such as alcohol, petrol and cigarettes.

I wouldn’t want to be the political front person for that package. Perhaps the Conservatives should give the finance portfolio back to Kenneth Clarke. In 1997 he lost the election no chancellor would want to lose. Whoever succeeds in 2010 will have won the election no chancellor would want to win.

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