Chancellor Alistair Darling Faces A Difficult First U.K. Budget on 12 March

• Markedly higher-than-expected surpluses in the public finances in January means that Chancellor Alistair Darling will deliver his first budget on Wednesday under better circumstances than had seemed likely only a few weeks ago. Despite January's buoyant performance though, the public finances were still weaker overall in the first 10 months of fiscal 2007/08. Specifically, the Public Sector Net Borrowing Requirement (PSNBR) was £26.5 billion during April 2007-January 2008, up from £20.5 billion a year earlier. Meanwhile, the current budget was in deficit by £8.5 billion, up from a shortfall of £3.7 billion a year earlier. This means that Darling is still far from certain of meeting his October Pre-Budget Report (PBR) targets of limiting the PSNBR to £38.0 billion in 2007/08, and the current budget deficit to £8.3 billion. At least though, any shortfall now looks modest and  Darling will not have to significantly change his estimates of the public finances in 2007/08.
• Nevertheless, Darling still faces a difficult time on Wednesday. The prospects for public finances in 2008/09 look bleak, as markedly slower consumer spending and GDP growth seem certain to undermine VAT and corporation tax receipts. In addition, a substantially softening housing market threatens to exact a significant toll on stamp duty receipts, while Darling has been forced to backtrack on his plans for Capital Gains Tax and the tax treatment of "non-domiciles."  Indeed, the Chancellor's target of cutting the PSNBR to £36.0 billion fiscal 2008/09 could well be missed by up to £10 billion as things stand.
• The Chancellor will clearly have to lower his GDP growth forecasts. When presenting the PBR back in October, Darling forecast that GDP growth would be 2.0-2.5% in 2008 and 2.5-3.0% in 2009. Global Insight expects GDP growth to be 1.8% in both 2008 and 2009, while the consensus forecast in February was for GDP growth to be 1.7% in 2008 and 2.0% in 2009. We suspect Darling will forecast growth around 1.75-2.25% in 2008 and 2.0-2.5% in 2009. Darling is likely to attribute much of the U.K. slowdown to a weaker global growth, tighter lending conditions influenced markedly by the U.S. sub-prime mortgage crisis, and high energy, food, and commodity prices, He may well also argue that GDP growth in the United Kingdom is expected to be higher in the Eurozone and United States in 2008 (consensus forecast was 1.6% and 1.6% respectively in February). However, this does not mask the fact that the U.K. economy has problems of its own (notably including high household debt levels and an over-extended housing market), while the public finances are in poor shape despite the economy experiencing extended robust growth during Labour's time in power.
• Darling stated recently that he will use March's budget to support growth, but the worrying state of the public finances suggest that he has no scope to take meaningful stimulative fiscal measures—as is happening in the United States. In fact, with public finances likely to be markedly weaker than forecast in 2008/09, there is a case for significant corrective measures to be taken in the budget. It is unlikely that the Chancellor will be prepared to enact major tax raising measures and/or public spending cuts at a time when the economy is faltering markedly. Darling will also be very aware that a general election is due by spring 2010 at the very latest.
• There has been some speculation that the Chancellor could amend the fiscal rules, especially as the privatization of Northern Rock means that public debt is set to rise above the 40% of GDP ceiling that is set under the current rules; even if only temporarily. There has also been pressure on Darling to revise the "Golden Rule," under which the current budget must be balanced during the economic cycle, with borrowing only allowed to finance capital investment. Although the government claims that it continues to meet this rule, the timing of the economic cycle has been moved so many times in recent years that it has lost credibility in many people's eyes. However, Darling stated in Parliament in early March that "the fiscal rules that we set up 10 years ago have served the country well. Those rules are important." This suggests that, for now at least, he is not planning any changes.
• Whatever the Chancellor does on Wednesday, he cannot afford to make any major policy announcements that subsequently need to be significantly amended. The fiascos over Capital Gains Tax and the taxation of "non-domiciles," on top of Northern Rock, have significantly damaged the government's reputation for economic competence, as well as Darling's own reputation. It has also done serious damage to the government's relationships with businesses. Any further embarrassments resulting from Wednesday's budget would be extremely hard for the government and Darling in particular, to live down.
• So what will the Chancellor do? We suspect not a great deal in macroeconomic terms as he comes to the conclusion that he really cannot afford to take major stimulative measures to support the economy, but also holds off from taking significant measures to bring the public finances back into line in the near term. We suspect that Darling will announce that the public deficits will be higher than previously planned in 2008/09 (but the deficit forecasts will probably still be lower than most analysts expect!) and he could well indicate that unspecified corrective action will be taken further out when the economy is on a firmer footing.
• There will obviously be some attempted eye-catching announcements, probably aimed at helping the very poor, and also perhaps relating to environmental taxes and initiatives. Raising some environmental taxes, or introducing new ones, could well be seen by Darling as a least unpopular way of raising some much needed extra money. For example, owners of gas-guzzling vehicles are likely to be hit again, while fuel tax may still be raised despite current record-high petrol prices. Darling is also likely to offer some modest incentives aimed at encouraging homeowners to take various environmentally friendly action. There has also been speculation that  Darling could impose a windfall tax on the utilities, although the generally feeling is that he will hold off from doing this.
• There could be significantly increased taxes on some forms of alcohol, particularly given the increasing concern over binge drinking.
• Major changes in income tax seem unlikely, although there is speculation that Darling could align income tax and National Insurance. It has already been announced that the basic rate of income tax will be cut from 22p to 20p in 2008/09, although this is largely countered by the abolition of the lower 10-p tax rate.
• On the business side, Darling should clarify the situation on Capital Gains Tax and the taxation of "non-domiciles." There is also speculation that he could announce changes in the taxation of businesses' foreign profits. It is not impossible that the Chancellor could trim corporation tax on top of the 2-p cut from 30 p to 28 p that has already been announced to come into effect in 2008/09, although this seems unlikely given the fiscal situation. The Chancellor may well announce some measures aimed at helping small firms, in an attempt to re-build the government's relationship with business, but these are likely to be limited.
• There have been calls for stamp duty to be reduced, or even suspended for a limited period on lower priced properties (as happened in 1992 under the Major government), to support the markedly faltering housing market and to help first-time buyers in particular to get a foothold. Again though, it is doubtful whether the Chancellor has the resources for this. He may also believe that such a move is not warranted at this time, given that some slowdown in the housing market is desirable, and it is not collapsing at this stage at least.
• Darling seems unlikely to make any major changes to public spending plans for 2008/9, despite some calls for him to trim expenditure to limit the fiscal deficits.