Analysts’ estimates of the fiscal outlook may be a little too rosy. In any case, difficult spending decisions lie ahead

As usual, the Green Budget prepared by the Institute for Fiscal Studies in conjunction with Goldman Sachs provides much the best indication of British public finances in advance of the Budget statement. But I have to admit that I find it somewhat too reassuring.

The central assessment is that Gordon Brown is well within his own self-imposed fiscal constraints. He can therefore afford to remit in taxes or increased public spending an amount that would cost about £1.5bn ($2.2bn) in the next financial year, rising to £3bn-£4bn in the year after that. Because of the greater than expected revenue inflow, this would do no more than bring him back to the projections in his last Budget. The IFS believes that a package of this size would also enable the chancellor to meet his medium-term fiscal rules in the next parliament with something to spare.

The reliefs suggested for the coming year would be equivalent to a cut in the basic income tax rate of 1 percentage point, although that is not what Mr Brown is likely to do. He has already indicated that he wants to give priority to selected groups such as families with children and also - more dubiously - to subsidise entrepreneurship and business research.

Both the Treasury and those who comment on its affairs are in danger of forgetting Murphy’s Law: that if anything can go wrong, it will. In the late 1980s the position looked just as comfortable; and the Organisation for Economic Co-operation and Development, together with other mainstream analysts, believed that, in spite of the controversial 1988 tax cuts, the Budget of that year in fact tightened the fiscal position (see chart).

The obvious cloud on the horizon this time round is the US economy. It is too readily assumed that Alan Greenspan, chairman of the Federal Reserve, will be able to make a series of further interest rate cuts to ensure that the economy bounces back by the end of the year.

Fine tuning is not that easy. George Soros has rightly warned that the Fed is more likely to do too much than to do too little. There is a danger that if it gave comfort to Wall Street bullishness, it could reinflate the stock exchange bubble as well as depress the dollar - and then have to impose renewed monetary tightening.

It is also too easily assumed that the US recession will have little overspill effect on Europe because the trade linkages are relatively modest; and that low inflation provides scope for European Central Bank and Bank of England interest rate cuts. But it would be a brave analyst who claimed to have located all the channels of transmission. More apt is the remark of Alan Blinder, former Fed vice-chairman: “Everyone gets hurt when the 800lb gorilla on the economic block slows down.”

The immediate danger in Britain is more of over- than of under-stimulus. A few distinguished analysts - including the monetarist Shadow Open Market Committee, speaking with rare unanimity - have said that the case for a further cut in interest rates this February is very weak.

Meanwhile, the overall size of the IFS package can be supported - but for different reasons from the ones given. In a progressive tax system, as incomes rise tax revenue increases automatically as a proportion of the national income - “real fiscal drag”. A package of £2bn or £3bn would simply offset this back-door tax increase.

The Green Budget also raises more fundamental long-term issues. Both the Conservative opposition and the Labour left project the 5 per cent annual increases in public spending expected in the present and forthcoming financial years for the whole of the next parliament. The Green Budget authors have, however, looked at the small print of Treasury statements.

These show that the present bulge - apart from coinciding with the general election - is intended to make up for the drastic clampdown on spending in the first three years of this parliament. All the revenue overshoot in those years was used to reduce public borrowing. From 2002 onwards real current spending is planned to rise by only about 2.5 per cent a year and capital expenditure will level out as a proportion of national income once it reaches 1.8 per cent. This would be more or less in line with trend economic growth.

The result is a middleway compromise. But isit really satisfactory?

The proposed medium spending path is hardly likely to be enough to satisfy the clamour for more and better public services. One possibility, highlighted by last weekend’s political events, is that Old Labour will take over from New Labour and that 4 per cent to 5 per cent annual public spending increases will occur over the whole of the next parliament and beyond. To do this without breaking his fiscal guidelines the chancellor would have to increase the tax burden well above the stable 40 per cent of gross domestic product now projected. This would be welcomed - at least before the event - by those members of the talking classes who would like to see a public sector corresponding to the “European social model”.

If Britain is to have decent public services, either the government will have to give in to this clamour from the left, or it will have to consider a much greater private contribution to health and education, which are, after all, as much private as public goods.

As John Stuart Mill pointed out a century and a half ago, the British public will fall for anything that is presented as a compromise between two extremes. Yet we have here a case where a compromise is worse than either extreme.

As a postscript, I have a specific tax suggestion for the chancellor. In 1867 Disraeli, the Tory leader, “dished the Whigs” by introducing a bigger electoral reform than anything that they were planning. The equivalent would be for Mr Brown to introduce, at least in the next parliament, a series of phased increases in the starting point of the higher 40 per cent income tax rate.

Although there were several reductions in the higher rate during the Tory years, the threshold was not raised in line with earnings and sometimes it was even frozen in cash terms. As a result the number of higher- rate payers has risen from fewer than 800,000 in 1980 to 2.7m; and the threshold has fallen to just over 150 per cent of average earnings. The extra people caught in the net are not “fat cats” but just the middle-class groups whose support New Labour has been so anxious to attract. The IFS case against a relief here ignores the all-important impact on marginal, as distinct from average, tax rates. If that starting point were moved back to its 1980 equivalent, there would be little of equal attraction that the Conservatives could offer to these groups; and the reform would do more for entre- preneurship and profession-alism than all the special incentives the Treasury backroom boys can invent.