Bill Jamieson: Public spending is the nettle that must be grasped

A BUDGET deficit spiralling to the highest in our post-war history; a plunging economy suffering its worst reverse in decades; soaring unemployment, rising business failures and a currency that's been on the skids for most of the past year: Chancellor Alistair Darling's big gamble on Wednesday is not so much with disgruntled voters as with international markets and investors on whom he is relying to buy a record volume of Government debt.

The Treasury's sales pitch is already sounding like an undischarged bankrupt applying for a self-certification mortgage. Spending is way ahead of income, asset values have crumpled, credibility is shot, the clothes look decidedly car boot and seven-day-old facial growth looks too rough for designer stubble. How on earth is the Chancellor going to reassure his creditors? And what is it he will have to do to prevent a panic exodus from the UK debt market and sterling – an outcome that would make an already chronic situation much, much worse?

This Budget is the worst of all possible worlds for the Chancellor. Never before has a big fiscal package been more justified to cauterise and contain a deep recession. But never before has the Treasury found itself more over-borrowed and overspent. This is a killer combination for any government. It dare not take the risk of launching the fiscal stimulus that the economy needs.

Michael Saunders, chief UK economist at Citigroup, says: "A big new stimulus could lift the deficit to levels – 15% of GDP or so – that might totally undermine confidence in UK economic management and lead to a path of fiscal crisis… When fiscal stimulus is most needed, it is not available. This is a major policy failure."

However, at least the Chancellor starts with two points in his favour. The first is that by the time he rises to his feet at 12.30pm on Wednesday the world will be well braced for the worst budget deficit figures in Britain's post-war history.

A combination of background briefings, leaks and inspired guesswork has left the media and public well prepared for the deficit numbers. They will still shock – but it should not be the shock of surprise. The budget deficit for the year just ended is expected to come in at around £90bn. For 2009-10 the projections are far worse. The consensus expectation is that the Chancellor will announce a figure close to £150bn, or 10.5% of GDP, the largest in the UK's post-war history.

Some estimates range higher. Treasury sources are thought to be responsible for a figure of £175bn emblazoned on the front page of the Financial Times last week. And Karen Ward, economist at HSBC, forecasts a 2009-10 Public Sector Net Borrowing figure of £177bn, equivalent to 12.5% of GDP. Even this is topped by Citi-group's forecast for the budget deficit for 2010-11: £190bn, or 13.4% of GDP – even with no new fiscal stimulus.

These figures will all but be discounted when the Chancellor presents the Budget. Indeed, any number lower than these will be greeted with some relief.

The second development in his favour is the Bank of England programme of 'quantitative easing'. Under this, the bank is buying assets from the banking system including Government gilt-edged stock. This has three effects. First, it puts more liquid cash straight into the banking system to be used for higher lending to business customers. Second it helps to keep down the yield on Government debt paper. And third, it secures an 'anchor buyer', at least over the initial period of the explosion in Government debt.

So while these should help avoid an immediate crisis in the wake of the Budget, it does not of course get the Chancellor off the hook. What international buyers of Government bonds (and sterling) will be looking for on Wednesday is assurance that the Government has some credible plan for bringing this spiralling debt mountain under control. The Budget will be unlikely to contain swingeing tax increases at this stage in the cycle. But the markets will need comfort that an action plan is in place and that falling debt projections for future years can inspire some confidence.

That means in turn a programme for action on tax increases and spending reductions. The slide into deficit nightmare reflects both a collapse in revenues from tax and also continuing central government spending increases. Figures for the April-February period show spending rising at a rate of 8.6% year on year versus plans of 5.3% growth in the 2008 Budget and 6.1% year-on-year growth in the Pre-Budget Report last November. The fiscal costs of recession are evident in the overshoots of debt interest and social benefits.

At the same time the falls in Government revenue have been startling. Central government receipts fell 3.1% year on year in April-February and they were falling at an annual rate of 10.1% in the last three months. The Budget last spring forecast a rise in receipts of 4.7%. Total general Government revenues in the final quarter of 2008 fell 5.4% year on year, the sharpest drop since quarterly data began in 1950, Saunders says.

For the full year 2008-09, Citigroup expects general Government revenues to fall by about 3% year on year, the biggest drop since full data began in 1946-47. In cash terms, this means a shortfall of between £40bn and £45bn compared with the forecast given in the spring Budget last year.

Little wonder the prophecies of swingeing tax increases kicking in from 2010 and 2011. There is talk the Chancellor could beef up the tax allowance claw-back due to take effect next year for those with incomes over £100,000. There will also be a new higher rate of tax of 45% for income over £150,000 from April 2011.

Other suggestions include a raising of VAT to 20%, which would bring the UK in line with many other countries in continental Europe. Another proposal is for a wealth tax to hit those with assets of £1m plus.

But the problems regarding higher tax are manifold. They destroy work incentives. They add to employment costs. They suppress entrepreneurialism and make us less competitive. The real nettle to be grasped is public spending – set to reach 48% of national income, and in particular the public sector payroll. This has now ballooned to £180bn.

This is the bedrock of the Labour Government's support. But growing numbers have queried the fairness of continuing bounty in the public sector while the private sector has to bear big cutbacks in jobs and investment.

And there is surely room to cut back on the estimated 529 quangos of which at least 111 have been set up since 1997. These bodies cost billions a year to run – many of them performing functions which are unnecessary or could easily be funded by the private sector. Organisations such as the British Potato Council, the Wine Standards Board, the Music and Dance Scheme Advisory Group and the Disruptive Passenger Working Group are in sore need of a weeding out.

Other ideas include the cessation of child benefit payments to top-rate taxpayers and a dismantling of the complex system of tax credits.

All this is before taking an axe to MPs' expenses and the array of spin doctors and smear merchants funded by the taxpayer. The savings may be small but what a signal it would send. And if the current Government isn't up to doing it, the message from this Budget is clear: market reaction will ensure it makes way for a new order with the guts to do what's necessary.