Crunch time for spending plans

By Steve Coulter, BBC Economics Analyst

The government is approaching a crunch point in its drive to revamp public services.

As the Chancellor, Gordon Brown, puts the finishing touches to his pre-Budget Report, he will probably have half an eye on next summer's public spending review.

The government argues that to put up taxes now while the economy is slowing would be ill-advised.

This will set spending levels for services like health and education for most of the rest of this parliament, and will be a key factor in the government's prospects for re-election.

But Mr Brown may soon face some difficult choices as he tries to juggle the public sector's demands for more cash with the worsening economic situation and Labour's manifesto pledge not to raise income tax.

Taxing speculation

There has been much speculation that spending and revenue problems over the slowing economy and the cost of war will empty the government's coffers and force it to put up taxes.

It is certainly true that the government's own projections see the budget surplus disappear over the next few years. Last year's £16bn surplus on public borrowing will turn into a £10bn deficit by 2003.

But Mr Brown's self-imposed fiscal rules are unlikely to be breached, as they allow him to dip into the red for a few years provided he has built up reserves.

Labour was rattled by anger over public services

In effect, the surpluses accrued earlier in the parliament are allowing him to run up debts now. Even a military campaign as expensive as the £2.5bn spent on the Gulf War in 1991 would not jeopardise this.

The government's finances are hardly running onto the rocks. Public Sector Net Debt fell 10% last year to 31.7% of GDP. It was 44.4% at the 1997 election.

The government argues that to put up taxes now while the economy is slowing would be ill-advised.

It would also go against the thrust of current monetary policy, which is to encourage consumers to keep on spending by slashing interest rates.

Changing situation

But the situation could well change over the next few years, as the economy picks up and holes start to appear in the public finances.

The Institute for Fiscal Studies says the government will need to raise taxes by £5bn each year in order to maintain growth in public spending at its current rate of 3.7% a year in the coming spending round, which covers the three years from 2003/04. This is equivalent to nearly 2p on income tax.

Labour was rattled during the June election campaign by public anger at its failure to match promises on services with results.

Although spending on health and education is now rising at its fastest rate since the 1970s, it has only been doing so for the past two years.

Spending before then was kept on a tight rein. A result of this earlier parsimony is that service chiefs are actually unable to spend the money they have belatedly been allocated.

The railways revamp is an expensive pledge

Peter Robinson, an economist at the left-leaning think-tank, the Institute for Public Policy Research, warns that the government will need to raise spending by a lot faster than its current rate if it is to meet its long-term political targets.

For example, on current trends it will take until 2011 for health spending to achieve Tony Blair's aspiration of matching the European average.

Other un-costed and probably very expensive pledges include expanding higher education to 50% of school leavers, new anti-poverty tax credits and the revamp of the railways. The latter will have been further complicated by the government's recent take-over of Railtrack.

Satisfying public demand

Mr Robinson warns: "Even if the government does deliver its spending commitments, will this satisfy public demand?"

Labour ruled out increases in the basic or higher rate of income tax during the general election campaign. But there are plenty of other ways to raise money.

A front-runner, at least in the press, would be to raise or abolish the upper earnings limit of National Insurance. Abolition would raise £4bn or so, and Brown has refused to rule it out.

Brown has not ruled out National Insurance changes

But tapping the National Insurance fund is problematical.

Michael Jacobs, of the Fabian Society, said: "In my view the government should not raise taxes by increasing National Insurance contributions.

"NI is an earmarked social insurance system. Contributions are paid into the NI Fund, which should be used only for NI purposes - the basic state pension and some other benefits.

"Any changes to fund general government spending would alter the basis of this social contract and would not be transparent."

Another good way of boosting the income tax take is simply not to raise the tax thresholds by very much, so that rising earnings push more people in higher tax brackets.

Economists call this "fiscal drag", and it accounts for a sizeable proportion of the rise in the tax burden so far under Labour.