Set against a tough economic outlook, Alistair Darling’s first Budget on 12th March is likely to prove a key moment in his mentor Gordon Brown’s bid to rebuild public confidence in this Government.

It will also be the first Budget since Gordon Brown moved from the Treasury to No 10, and there are a number of economic signals that the Chancellor cannot ignore and must prove able to counteract. The effects of the credit crunch will begin to be felt more acutely, economic growth has slowed, house prices tipped to fall, and the state of public finances has been distressed.

Furthermore, a series of challenges to the Treasury’s approach to capital gains tax, Northern Rock, and non-domicile taxation, have served to call into question the department’s heretofore sure touch.

This week’s Knowledgeshop examines some of the key areas likely to feature in next week’s Budget.

The Institute of Fiscal Studies (IFS) has said that it expects the economic outlook for the next few years to be “worse than it has been for some time.” It further forecasts a moderate slowdown in the UK economy over the next financial year followed by a rather weak recovery in 2009/10. Moreover, consumer spending is expected to weaken as incentives to save increase and the price of credit makes borrowing less easy.

Against such an uncharacteristically bleak backdrop, the Chancellor does not have the luxury of being able to blame his predecessor, nor of calling for more time in office.  Darling’s pre-budget report at the end of last year was criticised for being rushed and unclear. He was accused of being wrong-footed by the Conservatives and of copying opposition policies.

Despite the doomsayers, the Treasury will next week maintain that the UK’s economic fundamentals – low inflation, lowish interest rates and long-term, stable growth – are strong and put the country in good stead to weather the economic storms ahead.

There is everything to play for.

Rules made to be broken?

Many will want to see whether the Chancellor will admit that he has broken his ‘prudent’ sustainable investment rule, which dictates that total government debt must not surpass 40% of GDP, and that borrowing should be for investment only.

The nationalisation of Northern Rock has forced it up to a relatively high 45%, according to City analysts. Unlikely to allow his first Budget to be marred by broken rules, Darling is more likely to simply keep the £110 million Northern Rock liabilities off the balance sheet, hidden among the footnotes of the Red Book as an ‘exceptional circumstance’. This would be necessary in order to ensure his first Budget is heralded as a success. Creative accounting may be called upon to save the day.  

Nonetheless, the Institute of Fiscal Studies has said that many economists no longer see compliance with the fiscal rules as a good guide to the health of the public finances. In part, this reflects concern that Gordon Brown, when Chancellor, made accounting changes simply to make the golden rule easier to meet. The IFS estimates that in order for the Chancellor to keep net debt below 40% of national income and maintain the improvement in the current budget balance that he was looking for in the PBR, he would have to announce an £8 billion increase in tax. Given that this would be both politically and economically unfeasible, it is more likely that the Bank of England will offset the impact of fiscal tightening on growth and inflation. 

Public Finances

So what can we expect tomorrow? Given widespread fear of an impending global recession and slowing economic growth, the central focus of the upcoming Budget is likely to be long-term stability. Give-aways will have to wait until the run-up to the next general election as Government coffers are at present disappointingly empty. In his Budget last year, Gordon Brown forecast borrowing of £30 billion for the next financial year, yet Alistair Darling was forced to raise this to a further £36 billion. City analysts are suggesting that this will have to be raised even further- to as much as £44 billion.

Some gloomy forecasts are suggesting that growth could be as low as 1% this year. There is a possibility that the consumer slowdown might trigger a rise in unemployment, which could in turn cause further decline in house prices.

Observers suggest that the Budget will contain few genuinely new policy measures. The CBI last week called on the Chancellor to “ditch the theatricals” and restrict his Budget to six simple paragraphs because he “has virtually no room for manoeuvre”, and because as Richard Lambert, Director General of the CBI, said: “the sensible decision would be to slim down this year’s Budget to the bare necessities.”

It’s unlikely we will get a speech that short – but it seems unlikely, in the circumstances, that the Chancellor will want to linger at the dispatch box for longer than strictly necessary for the sake of form.

This will be no reforming Budget. It will be a Budget that seeks earnestly to imbue, once again, the Gordonian aura of Prudence and Stability.

No stepping on toes

The former Chancellor’s priorities will remain the same under his premiership.  His entire 2007 budgetary programme- income tax cut, 10 % rate abolition, and the 28% corporation tax cut- are all due to come into effect in April, and will therefore dominate much of the next year’s financial agenda. It is extremely unlikely that the Darling will in any way alter any of his predecessor’s policies. Rather, Darling will likely turn his attention to damping down economic fires before they erupt.

An end to ‘boozy Britain’?

The increasing political salience of the cost and accessibility of alcohol, particularly among the nation’s teenagers, is likely to force Darling’s hand into levying new taxes on cheap alcohol. Restrictions on cut-price marketing are likely. Drink will become the new fiscal demon, alongside tobacco. No swilling on Scotch for Darling.

The Environmental agenda

Green taxes will inevitably feature heavily in the Budget. A populist policy that appeals to the grassroots, in December Brown declared that “sustainability will be at the heart of the next Budget.”  Moreover, the Chancellor will hope to seize the initiative back from the Conservatives on environmentalism.

A major theme of the green agenda is likely to be aviation taxes. The Government has already proposed a tax on place, due to come into force November next years, to replace the current tax on passengers, to target emission levels more accurately. Domestic aviation is looking vulnerable.

Any further increases in fuel duty will be highly contentious, given current soaring oil and commodity prices- draining the pockets of the entire nation.   

The Enterprise agenda

Darling will face pressure over his capital gains and non-domicile taxation plans. While levies for both are due to come into effect in April, the Government has been under intense lobbying pressure from business to clarify their intentions in this area. 

The Government has promised to reduce business tax wherever possible, but unless it intends to borrow in order to pay for this, Darling will have to look to restructuring to make any such changes.

The Government’s proposals in the pre-budget report to remove taper relief and the distinction between business and non-business assets made large swathes in reducing the complexity of capital gains taxation. Nonetheless, as the IFS notes “announcing a reform without consultation, creating additional uncertainty by agreeing to rethink it in the face of intense lobbying, and then delaying the results of the rethink, are not the hallmarks of competent tax reform. It is hard to believe that whatever changes to CGT finally emerge this year will be the last.”

Despite the better regulation commitments of the Government, the business community says it is drowning in regulatory red tape. A meaningful lightening of the business burden should therefore be a priority for the Chancellor, particularly as this could be achieved at no public costs at a time when tax cuts are economically and politically unfeasible. Darling will also come under pressure to reduce the overall burden of business taxation.

Inheritance tax

Any further changes to inheritance tax are unlikely, despite being the most hated tax in editorial meetings of the Daily Mail. The Chancellor has been said to stumble in addressing this issue in his Pre-Budget Report, where, although he made it easier for married couples to transfer their allowances, he stopped short of a big increase in the threshold. The allowance is at £300,000 and is set to rise to £350,000 by 2010. Both opposition parties are calling for a £1 million threshold. Stephen Herring of BDO Stoy Hayward says: “Darling should increase the exemption threshold to at least £500,000, making sure that the tax hits those it was meant to, and not moderately affluent house owners.” Despite the obvious logic in overhauling inheritance tax wholesale, the Chancellor simply cannot afford it right now.

Housing Market Relief?

The Chancellor may look to increase the stamp duty threshold given that it is such a money spinner for the Government. Total stamp duty revenue from residential property sales rose by 40% in 2006-07 to a record £6.4 billion. But stamp duty hits homebuyers hard.  The average homebuyer in nearly one in three local authorities now needs to set aside the equivalent of more than 20% of local average earnings to pay their stamp duty bill, according to research from Halifax. Building societies have been calling on the government to raise the stamp duty thresholds. It would certainly make life easier for movers and first time buyers - and that might be a good thing given current market conditions.

In summary, tomorrow’s Budget will be restrained- with few give-aways and an overwhelming focus on economic stability given recent talk of turmoil. It will nonetheless, be of significant interest to all, not merely in terms of the economic agenda for the year ahead- but the extent to which this Government’s handling of the economy is seen to be a political asset, and not its undoing.