Has Britain’s recovery got the cutting edge?

The chancellor has faced a delicate balancing act in the PBR. He must persuade markets that he is serious about cutting the fiscal deficit over the medium term.

But cutting spending or raising taxes too quickly could seriously affect the timing and scope of any recovery. How can these aims be reconciled? Darling aims to persuade markets the recovery will be strong. In the short run, the government will raise public spending next year by 2.2% in real terms, while the economy begins its recovery. But from 2011, it plans to hold public spending roughly constant, while projecting economic growth of up to 3.5% a year.

If these growth rates come to pass, and public spending can be held roughly constant, then the projected path for the fiscal deficit is plausible. Tax revenues will tend to rise even faster than underlying economic growth, and they will gradually eat into the deficit.

But an important question is how plausible are these projections.

Independent forecasters are less optimistic – on average, they predict a growth rate of (only) 2.75% a year. This may not seem like a big difference but it would have a significant impact on the speed by which the deficit is reduced. By 2013-14, there would be a much larger deficit compared to the case with faster growth.

But even if growth is not as strong as the government forecasts, the fragile state of the economy might not survive the immediate treatment of large cuts in the deficit. So in any case cuts should be postponed.

But what choice does that leave? If growth does turn out to be as fast as the government predicts, then we can survive without large real cuts in spending. If growth turns out to be lower, then more radical action would need to be taken: cutting spending, raising taxes, or probably both. A more sophisticated strategy would be to acknowledge this.

The government could announce that – if necessary – the VAT rate will rise from 2012. This could provide a stimulus now as people bring forward spending to take advantage of the lower rate. If the faster growth actually materialises, then the tax rise may not be necessary. Such a strategy would respond to reasonable concerns that the growth forecasts may be too optimistic.

Professor Michael Devereux is director of the Oxford University Centre for Business Taxation at Saïd Business School