Will he still be smiling on Wednesday?

The lack of growth has blown the Chancellor’s deficit reduction plans off course. This week’s Autumn Statement will bring more pain, says Jeremy Warner

Elections used to be fought on the promise of tax cuts and spending increases, disingenuous though it always was for the politicians to bribe the voters with their own money. Even so, throughout much of the post-war period the political class has at least been able to point with a reasonable degree of justification to the genuine prospect of a better, richer, and more prosperous future.

No longer is this the case. The financial crisis has brought about a seminal change in the political debate. Though Labour may accuse the Coalition of delivering the wrong medicine for our economic ills, the only real dividing line these days is how quickly it is delivered, and where the burden of austerity should fall most heavily.

No politician can credibly promise any longer that you will be better off tomorrow than you are today. To the contrary, the only honest diagnosis is that collectively, we are almost certain to be worse off. One way or another, the overspending of the past has to be corrected.

It is this unappetising prospect that George Osborne, the Chancellor, must once again articulate to the nation when he gets up to deliver his latest Autumn Statement this week. It’s going to make acutely uncomfortable listening.

Two and a half years have elapsed since Mr Osborne announced his first, “emergency” Budget, and regrettably, things have not turned out as he had hoped. Back then, it all looked relatively straightforward. Admittedly, the fiscal challenges were daunting. The implied squeeze to bring revenues and spending back into line was the fiercest attempted by any Chancellor since the Second World War, bigger than even the Thatcher government had achieved. But it none the less looked a manageable proposition, and if anything, seemed somewhat unambitious given the abject collapse in the public finances which had just occurred.

There would be five years of pain, Osborne warned, but then it would be over and better times would return. The time frame was deliberately designed to coincide with the electoral cycle, so that in facing an election, the Government would be able to announce a job well done in getting on top of Britain’s debts, together with an expansionary Budget to tickle the voters.

Perhaps predictably, these plans have gone seriously awry, so much so that there is now every prospect that the Chancellor will have to admit on Wednesday that one of his prized fiscal rules that net debt will be falling as a proportion of GDP by the end of the parliament will not be met. Indeed, Osborne virtually admitted as much in comments over the weekend.

Was this a softening-up exercise in preparation for the political embarrassment of a climbdown, or just clever news management so that, to universal surprise, Osborne can announce he’s managed to remain on track after all? We’ll have to wait and see, but in any case the target of balanced budgets is, with each successive update on the public finances, being pushed ever further into the future. The fiscal squeeze will in all likelihood now have to continue at least until 2018, and possibly longer still. That means more spending cuts and tax increases on top of the ones already announced.

The problem is not that the Government is failing to do what it said it would, but lack of growth. Most fiscal consolidations, however ambitious, will always rely to some degree on growth to do the donkey work. If this fails to materialise, as has been the case in the past two years, then the plan is going to be in trouble. And how. In fact, the Government is now borrowing even more each year than was envisaged under the half-baked proposals for fiscal consolidation outlined by the last chancellor, Alistair Darling. In nominal terms, the deficit is getting bigger, not smaller. Both this year and next, it is likely to be larger than last year, with the Government set to borrow some £10 billion to £15 billion more in 2012/13 than the Office for Budget Responsibility (OBR) thought it would last March.

The deficit is only the difference between two extraordinarily large numbers revenues and spending so it might reasonably be thought that, in the scale of things, such a shortfall is not so bad. Certainly, it could have been a good deal worse.

Looking at the breakdown of this shortfall, the problem is entirely confined to the revenue side of the ledger, with growth in central government spending so far this year coming in quite a bit lower than the OBR thought it would. So that’s a plus. Unfortunately, tax revenues particularly corporate taxes, North Sea oil and gas revenues, and sales taxes (VAT and excise duty) are falling well short of expectations. This is where lack of growth is inflicting its greatest damage.

The problem the Chancellor faces is that the longer this lack of growth persists, the more the deficit has to be regarded as “structural”, or permanent. This increases the scale of the austerity Osborne has to impose to get the accounts back into balance.

The OBR’s forecast of output by the end of the parliament is already some 3.1 per cent lower than envisaged at the time of Osborne’s first Budget in June 2010, and on Wednesday, is likely to be trimmed back even further. Osborne’s task in getting the public finances back on the straight and narrow gets ever steeper.

Yet persevere he must. Despite two-and-a-half years of “austerity”, Britain still has one of the highest rates of government consumption as a share of GDP in the OECD. It’s primary deficit, moreover, is even bigger than that of Greece. That markets continue to allow the Government to get away with the sort of “austerity-lite” we have seen depends vitally on the belief that the Chancellor will eventually be as good as his promise and deliver the goal of balanced budgets. If markets begin to sense that deficit reduction is a sham, the UK would very quickly find itself in the same position as the eurozone periphery.

Osborne’s fiscal rules may in themselves be fairly meaningless, but he cannot ease back on the broad outline of fiscal consolidation without risking a catastrophic rise in interest rates. Growth sensitive “fiscal multipliers” tend in any case to be quite small in open economies such as the UK. Any benefit to be gained from doing what Labour suggests, and cutting VAT, would very likely only leach out into the wider world economy. There would be no permanent economic gain for the UK.

After the shambles of the last Budget, when the Chancellor was forced into a number of embarrassing U-turns, he’d perhaps be best advised to do as little as possible. The Autumn Statement is not, after all, supposed to be a Budget. But to maintain the credibility of his plan, he’s got to find further savings of some sort. And to get the additional squeeze he favours on working age benefits and public sector pay through his Coalition partners, he’s also got to find some way of whacking the better off. This makes a further paring back of pensions relief for higher-rate taxpayers all but inevitable, even though the effect is only to steal tax revenues from the future to fund the present.

All the same, this should create a little extra space in the Budget for growth-friendly infrastructure spending. Bringing such spending forward from the future to the present will also help the Chancellor meet his debt target further out.

Given that growth, or rather the lack of it, is the chief problem for the public finances, further significant supply-side reform must be an absolute priority, including a more realistic energy strategy and a meaningful easing back of planning controls.

In the meantime, progress in reducing the size of a bloated state remains depressingly slow. Health and pension commitments make getting state spending much below 40 per cent of GDP a perhaps unrealistic goal, but there is plenty more that can be done without tearing up the whole fabric of the social contract on the absurd overseas aid commitment, for instance, and on further reform of entitlement spending and public sector pay.

Making the economy competitive for today’s global race was never going to be popular, but if Osborne can get this even half right, it will be a legacy far more important than the faintly lily-livered and off-target deficit-reduction strategy which has been his main contribution to posterity thus far.