The macroeconomic analysis in the Pre-budget Report shows an element of realism after the optimistic forecasts produced on previous occasions. However, as far as the state of the public sector finances goes, the realism is limited to the short-term with tax shortfalls expected to be temporary.

  As far as the growth rate of the economy is concerned, the assumption of slower growth next year without any subsequent rebound must represent a change in the Treasury view of the normal level of output of the economy. Had they taken the view that next year's slowdown was due to temporary factors but that the normal level of output was unchanged, one would have expected to see an acceleration in the predicted growth rate in subsequent years. This is not present in their forecast, which therefore embeds a reduction of .5 percentage point in the trend level of output of the economy. Looking at 2009 my own expectation is, however for growth of around 2.25% rather than the figure of 2.75% cent used by the Treasury. While this difference is not large and forecasts more than a year ahead are not very accurate, it does have implications for future revenues.

  The Treasury continues to assume a trend growth rate of 2.75% per annum. Recent experience of immigration has demonstrated that this is a means of delivering faster growth than might otherwise have been the case. But an important point to recognise is that if immigration is a means of delivering faster economic growth it also raises pressure on some aspects of public spending, reducing the growth of spending per head of population and per user of public services. Migration-driven growth which might make the government's spending plans seem affordable may also reduce the quality of public services provided. Faster growth arising from immigration does not confer the same economic benefits as faster growth arising from faster productivity growth or rising labour force participation. However, the fact that the medium term public finance projections are based on a "cautious" growth rate of 2.5% per annum from 2010 onwards could be thought of as a way of taking some account of this effect.

  The Pre-budget Report shows a sharp reduction in expectations of current receipts as a proportion of GDP compared with the 2007 Budget, with the shortfalls arising mainly in income and corporation tax. Despite some tax increases announced in the Pre-Budget Report, half of the shortfall is expected to be almost made good by 2011-12 as Table 1 shows. This shows the same sort of medium term optimism about revenues which has affected Treasury forecasts of the public finances over the last five years or so and could not in any sense be described as a cautious forecast.

  With these lower revenues the share of public spending in GDP is also to be reduced, by half a percentage point of GDP in order to deliver the projected budget surplus. Thus the Pre-Budget Report displays a fiscal position substantially worse than that shown in the Budget.

  One minor oddity merits comment. Depreciation charges, which are added to current expenditure in order to work out the surplus on the current budget are slightly lower than in the 2007 Budget despite the fact that gross investment is expected to increase slightly. This has created a small amount of extra room for manoeuvre.

  If, as I fear, the current revenue weakness persists and real GDP growth in 2009 is slower than the Treasury hopes, then the current budget will probably not move back into surplus until 2010 or 2011. This does not in any sense imply that the current proposals are unsustainable or that the country faces a fiscal crisis. But at a time of economic boom with output above trend, as the Treasury recognizes, one would expect a current surplus rather than a current deficit and, in any case, given an ageing population the public sector should play a role in raising the country's savings rate.

  The Pre-Budget Report gives the impression that the medium-term projections are tailored to ensure that the cumulated current budget imbalance as a proportion of GDP remains in surplus averaged over the period since 1997-98. The Pre-Budget Report nevertheless acknowledges, for the first time (p 158) that the economic cycle, used in assessing the Golden Rule, is poorly determined, a point first recognised by the Treasury Select Committee five years ago. The case for a serious discussion about replacing the Golden Rule with a proper and usable prospective indicator of the fiscal position is as strong as ever.

  The substantial changes to the structure of taxation have been (i) the change to inheritance tax (-£1.2 billion in 2009-10), the consolidation of capital gains tax (+£0.75 billion in 2009-10), the change in the treatment of residence and domicile (+£0.8 billion in 2009-10) with changes to the second state pension and aviation duty raising about half a billion each in 2010-11.

  The joint effect of the changes we have seen is likely to be (i) to encourage buy to let investments because the tax rate on gains made on these is reduced and (ii) to encourage old people to live in large family homes because they no longer have to go through so many hoops in order to avoid or mitigate their inheritance tax bills.

  These changes do not give the impression that the Government has a clear view of what it wants to achieve through taxation. What should be the balance between taxing income from labour and income from capital? Is income from capital better taxed as a levy on wealth rather than a levy on income? Is there a coherent case for treating capital gains differently from income or should we go back to the 40% tax with indexation relief?

  The Pre-budget Report (p 150) draws attention to the possibly increasing importance of intangible investment in the British economy. This involves reclassifying as investment items normally treated as costs of production; it also implies an increase in gross profits in the economy. Changes in definition and structure of this type, although well founded, can be seriously misleading because the types of capital created typically depreciate rapidly. If these changes find their way into mainstream data there is a very strong case for focussing attention on a measure of output net of depreciation, net domestic product, as well as looking at GDP. An increase in GDP resulting from rising output of rapidly depreciating capital does not give the same benefits as a rise in GDP which finances durable capital investment or consumption spending. Net domestic product is not affected by these distortions.

10 October 2007