Clarke May Aim For Slim Tax Cut

The most he will be able to deliver is a one penny cut...there is simply no scope for a more significant fiscal easing, said Marian Bell, Royal Bank of Scotland economist.

Chancellor Clarke came under fire from the tax-cutting right wing of the Conservative party after declaring last week that voters would be deeply suspicious of large tax cuts because of broken promises on tax, made ahead of the 1992 election. But the real truth is he simply cant afford them.

The public sector borrowing requirement (government spending minus income, the PSBR) has been overshooting by miles...Clarke must opt for a prudent budget, said Jeremy Hawkins, economist at BankAmerica.

 

But when Clarke stands up to deliver his keynote speech to the Conservative conference in the seaside town of Bournemouth on Thursday, he will know many rank and file party members are anxious for chunky tax cuts to help the party recover in the polls before an election due by May 1997.

The issue came to the boil before the Party conference could even begin. The weekend British press carried calls from right-wing Conservatives for Clarke to be sacked, not only for his apparent reluctance to produce a give-away November 26 budget but also because of his enthusiasm for a single European currency.

While many in the Conservative party believe Clarke is too prudent on taxes, financial markets are worried he may not be prudent enough on fiscal and monetary policy as the election nears.

Economists warn that sharp tax cuts could seriously backfire on the Conservatives, as the financial markets react negatively to an over-generous tax hand-out that hikes government debt.

There is a real risk that a generous tax giveaway would push down sterling and push up bond yields as financial markets take fright, said Hawkins. That could see short-term interest rates forced higher, by 25, 50 or even 100 basis points.

That in turn would force up mortgage rates which would have serious political consquences for the Conservatives in a nation where 67 per cent of the population own their own homes.

Economists and tax experts said Clarke delivered a political dividend for the Conservatives after a cautious budget last year, in the form of the lowest mortgage rates for three decades and a recovery in the housing market after a severe fall in prices between 1989-1994.

And sharp tax cuts now, which might upset the financial markets, would simply endanger this valuable dividend and possibly undo the govErnments efforts to repair its reputation for economic competence after the deep 1990/92 recession.

Sharp tax cuts would certainly contain serious risks of a negative financial market reaction, said Chris Giles, senior research economist at the Institute of Fiscal Studies.

While a one penny reduction in the 24 per cent tax rate saves the average taxpayer around 10 pounds per month, that could easily be eaten up by consequent rate rises. A mere quarter point interest rate rise would take around nine pounds off the average mortgage payer.

And even if short rates were not pushed higher, fixed rate mortgages running for two years or more could move sharply higher as bond yields rise, economists said.

Mortgage rates are currently hovering around 6.75 to 7.00 per cent, well below a 10-year average running at around 10.5 per cent.

The last thing Clarke can afford is for mortgage rates to be forced up and the recovery in the housing market to be halted, said Hawkins.