Osborne’s Borrowing Headache Starts to Ease

In the 21 months since the coalition government has been in office, a narrative has been developing.

It is that George Osborne’s fiscal strategy is not only crippling the economy but failing in its own right by missing its targets for cutting the deficit.

Every time the chancellor stood up to announce an increase in the official borrowing projections, it seemed like a nail in the coffin for the strategy.

For Labour, a cumulative upward revision of £158 billion in borrowing over the parliament by the Office for Budget Responsibility, provided a stick to beat Osborne.

Well, unless January turns out to have been an aberration, the tide looks to be turning. Last month’s £7.8 billion budget surplus put the government on course for an undershoot of the OBR’s £127 billion projection for borrowing this year, 2011-12.

You may say that is no big deal. After all, did not the OBR revise up that forecast as recently as November? Yes it did, from £122 billion. It will be disappointing, however, if borrowing is not below that figure too.

Indeed, if the optimistic forecasters are right, the deficit could undershoot by £10 billion. “A simple extrapolation of the data over the last ten months suggests that borrowing is on course to come in at around £116 billion,” says the IFS.

There is many a slip twixt cup and lip. The OBR is not yet ready to throw in the towel on its forecast and there are two months’ figures to go. But this is rather interesting. Just over three years ago the Treasury under Alistair Darling predicted a budget deficit of £176 billion for 2010-11 and £140 billion for 2011-12.

In June 2010, when Osborne presented his emergency budget, the interim OBR predicted deficits of £149 billion and £116 billion respectively.

The £149 billion was far too gloomy (as was the earlier £176 billion), the outturn for 2010-11 being just under £136 billion. But that £116 billion for 2011-12 appeared to fall foul of weak growth in the economy.

Until now that is. If it turns out that borrowing is close to those initial June 2010 projections, in spite of a weaker recovery, some of the OBR’s gloom about future years may have to be revised. The fiscal strategy looks to be much more on track than it was given credit for. The deficit is still with us but is coming down faster than feared.

As an aside, the latest numbers makes the decision to put Britain’s AAA sovereign debt rating on negative watch look even more curious. It would have made a lot more sense to wait for the data from the key tax-raising month of the year.

Myths abound about fiscal policy and its impact on the economy. One is that the American economy is doing better because it has had a fiscal stimulus while Britain is doing exactly the opposite, inflicting unnecessary pain on a sickly economy.

Not true. The International Monetary Fund’s fiscal monitor shows fiscal policy in America was tightened by 0.8% of gross domestic product last year.

This was not as much as Britain’s tightening, 1.5%, but Britain’s was smaller than Germany, 2.3%. Germany, in spite of this, grew by a robust 3%. The relationship bewteen growth and fiscal policy is not simple.

Another myth worth exploding is that we have barely scratched the surface of the fiscal tightening, so that all the pain lies ahead. While it is true that the squeeze on spending will last for years, Treasury numbers, updated by Goldman Sachs, suggest the biggest single-year hit is behind us.

That was in 2010-11, a combination of the measures the coalition inherited from Labour, its own “in-year” cuts and the Vat hike in January last year. Policy, measured by the cyclically-adjusted primary balance, was tightened by a substantial 2.6% of GDP. This year’s tightening, by contrast, is 0.9% of GDP, roughly what it will average in future years.

Where does this leave Osborne as he plans his March 21 budget? He will be spared the embarrassment of having to present upwardly-revised borrowing forecasts and downwardly-revised growth.

He is being pressed by the Tory right to announce aggressive tax and spending cuts. The Liberal Democrats want the rich to be soaked more, by scrapping higher rate pension tax relief or introducing a mansion tax. I have an image of Ed Balls, the shadow chancellor, wandering up and down Oxford Street with a “Cut Vat now” placard around his neck.

I may have misread it but I would be surprised if he were to do any of this. The usefulness of the Tory right to the chancellor is that they make his plans look moderate. Neither the abolition of higher-rate pension tax relief nor a mansion tax are likely to see the light of day, for now at least. An emergency cut in Vat is about as likely as Elvis turning up at the Commons on budget day. Osborne will make a virtue of “steady as she goes”, banking the undershoot rather than spending it.

What about the 50p tax rate? Though self assessment receipts were disappointing in January, suggesting the absence of any revenue bonanza from the tax, the question of whether the 50p rate raises any net revenue is not yet cut and dried.

We await the verdict of Her Majesty’s Revenue and Customs (HMRC), which will be published with the March 21 budget. The politics of early abolition of the tax are awful. Even if it is a revenue loser, many people would want to keep it.

Osborne can, however, give a pointer to future abolition. He can also, and I feel bound to mention it given how many readers got in touch, tackle an absurd anomaly in the income tax system.

This is the 62% (combined tax and National Insurance) rate that kicks in when incomes hit £100,000 and continues to £114,950, after which it drops to 42%, until the 50p rate takes effect at £150,000. It happens because of the withdrawal of the personal tax allowance above £100,000.

The numbers caught in this anomaly are hard to come by but must be at least a couple of hundred thousand. As importantly, it introduces a powerful distortion and disincentive into the system. It needs to be changed.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

This post originally appeared at David Smith’s EconomicsUK and is posted with permission.