Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum submitted by Tenon Economics

  Three thoughts on the budget tax increases:

    1.  They were probably not strictly speaking necessary, and certainly not on the scale set out.

    2.  The tax increases could have been structured so as to improve the chances of the Treasury carrying out a positive assessment of our convergence with Euroland early next year, but they were not.

    3.  Some 80 per cent of the net increase in taxes by 2004-05 falls on business.

  The object of this briefing note is to explain the above statements.


  1.  The Treasury uses two rules with regard to the public finances.

  (a)  The "golden rule" to the effect that borrowing is only permissible to finance net public investment (NPI), and not to fund current spending;

  (b)  The "sustainable debt rule" which states that the net debt owed by the Government at any one time (ie the Government's total overdraft) must not exceed 40 per cent of GDP.

  When borrowing is less than NPI, there is said to be golden rule surplus; where by contrast borrowing is more than NPI, there is said to be a golden rule deficit.

  2.  According to the public finances forecasts set out in the Budget Red Book, the effect of the tax rises is more or less equivalent to the forecast "golden rule surpluses", as projected over the years, as follows:

Golden Rule Surplus
Projected effect of tax increases announced in Budget 2002

  3.  Thus even without the projected tax increases, the golden rule would more or less have been met during the forecast period. The sustainable debt rule would also have been met (without the tax increases, sustainable debt as a proportion of GDP by 2006-07 would be no higher than c 33 per cent). It should be noted that throughout this period the economy is forecast to be broadly on trend in terms of growth.

  4.  The inescapable conclusion is that taxes have been raised under cover of the required NHS spending increases, but that the real motivation behind tax increases is to provide Chancellor Brown with room to manoeuvre in the run up to the next Election: don't be surprised to see a cut of 1p in the basic rate of income tax in (say) 2004 financed out of the "Budget 2002 War Chest".


  5.  In early 2004, the Treasury is expected to carry out an assessment as to whether the Chancellor's five tests for joining the Euro have been met. One of the five tests is that we need to have achieved economic convergence with Euroland.

  6.  The three key elements to economic convergence between any two economies are a comparison of the following indicators as between the two economies:

  (a)  inflation rate;

  (b)  short interest rate;

  (c)  output gap (the output gap is the difference between an economy's actual output at any one time, and it is estimated sustainable long term capacity at any one time). When an economy is producing at above its estimated sustainable long term capacity at any one time it is said to have a "positive output gap" (and might colloquially be described as "over heating"; by contrast, where an economy's actual output is below its sustainable long term capacity at any one time it is said to have a negative output gap, and colloquially might be described as "in recession".

  7.  Currently our interest rate is 0.75 per cent above that of Euroland, our inflation rate is 0.9 per cent below that of Euroland, and our output gap is around -0.5 per cent, whilst Euroland's output gap is around -2.5 per cent.

  8.  A Budget strategy to minimise the divergence between the UK and Euroland by early 2003 in respect of the first two indicators (a) and (b) above would have been as follows:

  (a)  raise VAT in this financial year in order to close the gap between our inflation rate and Euroland's inflation rate;

  (b)  raise taxes on consumers this year, in order to ward off any danger of the Bank of England having to raise UK interest rates this year in order to rein in consumer spending thus in turn increasing the divergence between the UK's interest rate and Euroland's interest rate (which is broadly expected to remain static, and certainly is not anticipated to go up anything like the amount that UK's interest rate might go up by this year) in early 2003.

  9.  Significantly, the Budget did neither of the above. This was not a Budget prepared by a Chancellor who is straining at the bit to join the Euro.


  10.  It is instructive to review the make up of the total net tax increases announced in Budget 2002 for (say) the 2004-05 tax year, totalling £7.6 billion. Of this £6 billion will fall on business, some 80 per cent. This was a Budget to hit business, and not the consumer.

April 2002

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