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Last Updated: Thursday, 11 December, 2003, 17:44 GMT
Chancellor to squeeze wages
By Steve Schifferes
BBC News Online economics reporter

Government spending is likely to increase more slowly in order to stem the flow of red ink from the Treasury.

And the salaries of public sector workers will be squeezed by using the 2% inflation target as a benchmark.

Budget experts at the Institute for Fiscal Studies (IFS) say there is now little room for manoeuvre in the next spending round due in July 2004.

The moves come after the Chancellor admitted that he would have to borrow 10bn more than planned this year.

Borrowing shock

Mr Brown said in the pre-Budget report on Wednesday that this year the government will borrow 37bn, 10bn more than predicted in the Budget in April, and that borrowing will also be higher in subsequent years.

BUDGET DEFICIT FORECAST ( Budget forecast in April)
2003/4: 37bn (27bn)
2004/5: 31bn ((24bn)
2005/6: 27bn (23bn)
The new figures mean that the Treasury will breach its own rules if spending runs higher, or taxes lower, than expected over the next few years.

With an election looming, the government would prefer not to raise taxes, so attention has been focusing on how to curb spending.

Mr Brown has already told departments he will scrutinise their budgets for efficiency savings ahead of the next spending round, which will be announced next summer.

But experts at the IFS have discovered that Mr Brown has already made a cut of 1bn per year in the departmental spending budgets from 2005 by assuming a higher rate of inflation.

Cash squeeze

Since budgets are fixed in cash terms, this means that in real terms their spending will decline.

We still suspect that further tax increases will eventually be necessary if the Chancellor wishes to stick with his current spending plans
Robert Chote, director, Institute for Fiscal Studies
Carl Emmerson of the IFS told BBC News Online that it was likely to be a tough spending round, with tax rises the only way to fund additional spending requests.

With the government committed to big increases in health spending, other spending departments will have to content themselves with no real increases over the next 3 years.

The squeeze on spending also helps explain why a number of government departments are suddenly so keen to introduce charges for their services, from the plan to raise tuition fees to fund universities to the Home Office announcement that it will charge immigrants to Britain 500 to stay here.

Inflation tricks

It has also become clear that the Chancellor hopes the new inflation target of 2% can help curb wage rises in the public sector.

Old target: 2.5%
New target: 2%
ECB target: 2%
He made it clear to the unions that he intends to use the new target as a benchmark for setting wages in the public sector, as well as the target used by the Bank of England's monetary policy committee in setting interest rates.

"Because discipline in pay setting is essential in both private and public sectors, I have written to the public sector pay review bodies informing them that our inflation target is 2%", Mr Brown said in his pre-Budget report.

On Wednesday Mr Brown told the Bank that he was changing the inflation target from 2.5%, based on RPIX, to 2%, based on a measure known as CPI (the consumer price index), which is used in Europe and the USA.

But unions are furious, since his new CPI measure of inflation is consistently lower than the traditional RPI measure because it excludes all housing costs.

TUC general secretary Brendan Barber said that "if this is going to be used to hold down wages it would send alarm bells ringing throughout the public sector."

Budget fiddle

The Institute for Fiscal Studies says that Mr Brown has used various tricks to reduce the size of the budget deficit.

  • The Chancellor has eliminated the "contingency reserve" of several billion pounds which is set aside in future budgets to cover emergencies. Restoring this to normal levels would cost 2.7bn in next year's Budget.

  • After increasing child tax credits, the Chancellor has frozen other tax credits and thresholds , rather than increase them with inflation, saving 250m this year and 1.3bn by 2007/8.

  • The Chancellor has assumed that the extra costs of the Iraq war will fall sharply next year, and end in the following year.

  • The Chancellor has added 10bn to his margin of error in meeting the "golden rule" on balanced budgets over the economic cycle by changing the way he calculates the figure.

Golden rule fudge

Under Mr Brown's "golden rule", the government can only borrow to invest, not to meet current spending.

But the test is calculated over the whole of an economic cycle, from boom to bust and back - which according to the Treasury, covers the period from 1999 to 2006.

Mr Brown built up huge surpluses in the early years of the Labour government, which he is now offsetting against his growing budget deficit.

But the estimated total size of those cumulative surpluses has been falling rapidly as each year's budget deficit mounts, from nearly 100bn two years ago to near zero.

Mr Brown says that he will meet his overall target with only 14bn to spare, a relatively narrow margin of 0.2% of GDP.

But the IFS says the real figure is 4bn, a tiny margin that is well within the limits of forecasting error.

The reason for the change is that Mr Brown decided that the huge surpluses he built up in earlier years should count for more than the deficits in later years (since the same amount of money was worth less because of inflation).

So he decided to calculate each year's surplus or deficit as a percentage of GDP, rather than use the cash figure, when adding up his cumulative surplus.

Future problems

The IFS is also sceptical that Mr Brown will be out of trouble when the next economic cycle starts.

It points out that Mr Brown has assumed, for the first time, a sharp rise in tax revenues beginning in 2005/6, in order to restore the long-term budget to balance.

But the IFS's director, Robert Chote said that, with no new taxes pencilled in, the Chancellor was "over-optimistic about the medium term path of tax revenues.

"We still suspect that further tax increases will eventually be necessary if the Chancellor wishes to stick with his current spending plans."

Tax receipts from income taxes had fallen by 4bn because of the "wrong kind of GDP growth", which has boosted business investment rather than wages.

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