Back to the days of borrowing

THE direct impact on the City from the pre-Budget report looks limited. The Chancellor made much of the tax cuts to support business, but in terms of cost to the exchequer, the sums involved are minor league.

The big numbers in the package are the well deserved assistance to pensioners, making up for Labour's parsimonious first term, and the sharp decline in corporation tax receipts as the economy slowed in recent months.

These numbers may seem unconnected, but they lead in one direction, which is a return to public sector borrowing after the years of surpluses and debt repayments.

The new reality was not lost on the City. If the public finances look set to worsen with a strong forecast for future growth in the economy, imagine how bad they could get should the upbeat economic forecasts fail to materialise.

The first reaction was seen in the market for government stocks. Gilts were already weak before the Chancellor got on his feet because of concern that the British economy, despite global gloom, is moving along a little too strongly for comfort.

Brown's words did not help. The market view is that the fiscal stance is becoming more aggressive, which means more government stocks being issued. Halifax group treasurer Steven Pearsons observed that 'fiscal policy is going to remain expansive over the next two or three years' and the market thought Brown's growth numbers a 'little on the optimistic side'.

Certainly, at the shorter end of the market, there are signs that this year's lengthy run of interest rate cuts, bringing them down to 4%, could unwind in 2002 as higher borrowing and firmer growth kick in. Up to yesterday, the futures market was signalling that base rates would rise to 5% by the end of next year.

After the Budget package had been absorbed, expectations rose sharply, with the market pushing the rate up by a further quarter to 5.25% - a hefty rise in a day.

Perhaps the City should also have kept its eye on Monetary Policy Committee member Sushil Wadhwani, who has become the MPC's leading dove. He plainly believes that Bank of England deputy governor Mervyn King, like the Chancellor, is over-optimistic on Britain's prospects. King says there is only a one-in-ten chance of Britain going into recession.

Wadhwani put the odds at one in four. If this were the case, the Bank's room to bring interest rates down further, as they have done in the US, would be limited by the expansionary budget stance.

Despite the Chancellor's optimism on growth, which ought to be good for shares, there was certainly no great celebration in the City, where redundancy notices are still spreading and last year's bonuses are vanishing with the autumn leaves.

It would take a great deal of courage to buy the FTSE at present levels until there are signs that fundamentals, in the shape of company earnings, are finally recovering.

Work reforms
IN THE context of Britain's trillion pound economy, revealed in the Budget document, many of the Chancellor's latest measures look like small beer.

The decision, for instance, to introduce a flat rate of VAT for small businesses costs the Exchequer just £25m. But this, and several other new measures, are a step in the right direction.

There is an increasing recognition by Brown and his Treasury henchmen that many of the changes he has made to the tax and benefits system are over-complicated, and have added to the burden for business.

The flat rate of VAT and the decision to abolish stamp duty on the sale of properties worth less than £150,000 in 2,000 wards across the country will, at the margin, limit the burden on small and medium sized enterprises.

One of the biggest burdens for smaller firms - the switch from a benefits-based system to tax credits that encourage work - has still not been fully addressed.

The pre-Budget report provides some new bells and whistles which broaden the nature of the working families tax credit to support all working households but especially those with children.

The principle of addressing poverty by making lower-paid jobs worthwhile is sensible enough. But it needs a huge amount of refinement. In particular the government needs to provide direct support to smaller companies to run payrolls systems, which have become too complex, difficult to operate, and subject to frequent change.

The problem with using the tax system for social engineering is that it produces unintended distortions that undermine public support.