Growing deficit is Osborne’s big headache

With the UK budget deficit this year expected to be close to £100bn rather than the £40bn targeted, Chancellor George Osborne clearly has left himself very little room for pleasant surprises in his Autumn Statement tomorrow.

Indeed the deficit is 6% higher for the first seven months of the current financial year than it was in 2013-14. The UK's debt pile has now hit £1.5trillion up £150bn in just a year.

Against a backdrop of a surging UK economy, with unemployment falling, the growing black hole in government finances will be Osborne's Achilles heel on the big day, a major point of attack for the Opposition. So how has he managed to get into such a pickle?

Try 6 free issues of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

An analysis by John Redwood, chairman of the investment strategy committee at Charles Stanley Pan Asset, shows that the coalition has actually managed to keep current spending - the cost of running government excluding the purchase of major capital items like new buildings and roads - under control as planned. At the same time it has been able to increase capital spending while still keeping the totals slightly below the original forecasts.

Redwood says: "The higher than planned deficit is entirely down to weaker revenues, not to higher spending. We are borrowing substantial sums in order to sustain further cash increases in public spending."

He adds: "The government has decided to live within the original spending totals, and borrow more to cover the shortfall in receipts. It hopes that as the economy recovers so tax revenues will pick up."

Redwood provides some examples of where receipts have failed to materialise as planned. In the 2010 budget the Chancellor forecast income tax receipts of £158.4bn from PAYE and £35.1bn from self-assessment for 2014-2015. By March 2014 these forecasts had fallen to £142.2bn and £27.2bn.

"This decline of £18.4bn reflects the decision to raise income tax thresholds more, cutting income tax receipts from lower earners. At the same time, the higher top rate of tax has collected less revenue than expected. "

In 2010 the government forecast £1.6bn of petroleum revenue tax for 2014-15, recognising the likely fall in oil tax revenues. "Today we must be looking at a figure of practically nothing, given the decline in output and in the oil price," says Redwood.

Meanwhile, National Insurance is £10bn down on the 2010 estimate for 2014-15, despite the increase in employment. Offshore (oil based) corporation tax is down by £6bn, and total corporation tax is down by £15bn overall, in part owing to cuts in rates.

As Roger Bootle of Capital Economics points out in the Daily Telegraph, a major reason why revenue from income tax in particular has fallen so short of expectations is that so much of the recent job creation has been in low-paying jobs. The tax hit from this factor has been exacerbated by the increase in the tax-free personal allowance to £10,000 per annum, he says, with both the Conservatives and Liberals committed to increasing this allowance to £12,500 by the end of the next parliament.

Bootle is not convinced the taking of more people "out of tax altogether" is such a great idea: "The awkward truth is that however attractive a particular tax gimmick might be, unless government spending is reduced it will merely transfer the burden elsewhere."

He is certain that whoever wins the upcoming election, several more years of austerity lie ahead if the deficit is to be eliminated. He believes public spending in particular will need to be squeezed much, much more.

Osborne will not want to talk about more years of austerity so close to an election. In recent days he has looked to create a climate of optimism with announcements of big spending on capital projects covering roads (£15bn) and flood defences (£2.3bn) as well as £2bn on front line health services in NHS England.

Osborne insists he has nothing left to giveaway in the Autumn Statement. Well, it will be a first if that happens. The Daily Telegraph reckons tax cuts for widows and widowers who inherit their partners' annuity pensions and a freeze in petrol duty to help millions of motorists have been pencilled in as sweeteners.

Redwood sums up what is in store for us tomorrow: "Bulls can look forward to the government talking positively about the good growth rate of the UK economy, new jobs, new investment and even signs of rising real wages. Bears will hear the opposition voices pointing to the deficit, slow or no growth in real incomes, more spending cuts ahead, and the talk of tax rises to come."