Hamish McRae: Next chancellor needs to make us feel richer

It is time to start thinking of the task of the next chancellor. The balance of probability is surely that someone else will have taken over from Gordon Brown by the summer of 2005, little more than 18 months away.

To say that is not to suggest that the baton will pass to the Tories, which though possible must be considered unlikely. Nor is it to buy into the present speculation that Mr Brown is shaping up for a challenge to the Prime Minister. No, the point is simply that if Tony Blair is still in office after the next election, he will want to reshuffle the team. And if he is not in office, well, either Mr Brown does get his job or someone else does. Either way, the chances of Mr Brown remaining chancellor must be very slim.

So what will be the legacy? Gordon Brown was hugely lucky in inheriting both the second half of the long 1990s boom and the earlier structural reforms carried out by successive Conservative governments. But he also inherited a significant budget deficit and a record of macroeconomic instability. The first he cured by tweaking taxes; the second by passing control of interest rates to the Bank of England.

The record in the second term has been less impressive. Macroeconomic stability has been maintained through a more difficult global environment and that deserves all credit: to have kept growth going right through the downward part of the cycle is an achievement unmatched by any other large developed economy. However, this has happened at the cost of a surge in public spending, mostly of doubtful quality, and heavy borrowing to cover it. In addition the structural advantages of the UK economy have been narrowed by an overly complex tax system.

As a result, his successor will inherit three main problems. The first will be the state of public finances. We will learn next month more about the deterioration of the fiscal position when the pre-Budget Report is published. However, what seems to be happening is that revenues will disappoint and higher spending has not delivered the improvement in the quality of output that the Chancellor had expected.

The revenues side is particularly troubling as the growing economy ought to be delivering more tax. The simple explanation is that as times have become tougher, both companies and individuals have sought, with some success, to minimise their tax bills.

All developed economies are experiencing the same phenomenon to some extent - the problem of a tax shortfall is not unique to Britain - but this will still be a problem the next chancellor will have to solve.

Problem number two is the pile of debt that consumers have been allowed to accumulate. It is not just the Government that has borrowed big. The first graph shows how consumers' reliance on debt has reached similar levels to the later 1980s, mostly driven by mortgage equity withdrawal but also by regular consumer borrowing.

There are two mitigating factors. One is that the debt service cost is much lower than it was during the late 1980s and early 1990s. Not only are interest rates much lower; they are much less likely to rise sharply. The other is that some of the mortgage equity withdrawal is actually new investment. If someone borrows an extra £50,000 to build another two bedrooms in the loft that counts as consumption.

If they borrow to move into another house costing the extra £50,000 but with two more bedrooms, that does not. Insofar as money taken out is used on home improvement, it really is increasing the value of the underlying asset and so, provided the owner can afford the monthly instalments, should not add to the real debt burden.

The problem now that did not exist in the 1980s, though, is the real value of the debts. Looking forward, inflation is unlikely to cut the real value of loans to the same extent that it did in the 1990s. The current cost of indebtedness may be lower but the long-term real burden may be higher.

As people come to realise this rising real burden of their debts, they may well feel the need to trim their spending. The third problem the next chancellor will face - indeed we will all face - will be the continuing squeeze on personal incomes. Real incomes have been rising since 1995 (see the other graph) but have recently stopped doing so. We are only able to increase our living standards by borrowing, which will decrease living standards in the future. If taxes have to rise the squeeze will be all the greater.

So the next Chancellor will face a disgruntled voter. It is possible that in another 18 months' time living standards will be falling. It is almost inconceivable that living standards will rise by as much in the next five years as they have in the past five. At the very best real incomes may creep up by 1 per cent a year.

That, I think, will be the greatest problem facing the next chancellor: how to make people feel richer. What are the options?

One will be to hold down the growth of public spending. Some sort of clampdown seems inevitable, the only issue being how severe this is going to be. The trick will be to deliver better quality output for not more inputs but that is very difficult to achieve in the public sector. Some international comparisons suggest that were we to follow best practice, we could improve public services without putting more money into them. But we clearly have a lot to learn.

The second option will be to simplify taxes. The aim should be to turn companies' energy away from hunting for loopholes in the tax system into improving their output. There is always a clash between efficiency and equity, for efficiency demands simplicity while equity requires tax treatment to be tailored as far as possible to individual circumstances. But under Gordon Brown the balance has slipped too far in one direction. In any case once a tax system becomes too complex it does not really achieve equity: all it does is reward the people who are clever at exploiting the new rules.

A third option will be to maintain borrowing at a fairly high level: i.e. not to cut back the deficit too quickly. There are decent arguments for that course of action but the help borrowing gives is only marginal.

The fiscal deficit this year will be about 3 per cent of GDP. It could creep up a little from that level but not much. I suspect that the next five years will see a squeeze on governments all over the world. The fact that other governments have even higher deficits than ourselves does not help us; it just means that there is even more global competition for savings. So everyone will tend to pay higher interest rates.

Bottom line? The next Chancellor will have a much harder task than the present one. And that, you might think, would be a rather good argument for Mr Brown wanting to move on as quickly as he can - to get out while he is still ahead. Pity there is only one job he wants to do next and it, for the time being at least, does not seem to be available.