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Fiscal cuts: unprecedented action required

LONDON (Reuters) - The deficit-busting pledges of the new government have been described as “strong and powerful” by the governor of the Bank of England but will be far easier said than done and unprecedented in scope.

Prime Minister David Cameron’s Conservative party campaigned on an austerity agenda that implies public services spending cuts for the next five years, building to almost 60 billion pounds by 2015.

That is a tough order considering even Margaret Thatcher’s austerity drive in the 1980s did not actually cut spending in real terms, and that Britain has never suffered spending cuts for more than two years running since World War Two.

Strip out areas the government has promised to protect, such as health and overseas aid, and cuts to remaining departments’ budgets could be as high as 25 percent, according to analysis from the non-partisan Institute for Fiscal Studies.

The arithmetic looks challenging enough. The reality could be even tougher.

To secure a coalition deal with the Liberal Democrats the Conservatives have been forced to make a number of new spending pledges, all of which will add to the deficit tally.

And there are question marks over whether the new fiscal watchdog -- established by the Conservatives to cast an independent eye over government figures -- will agree with the assumptions on growth and future tax receipts used by the previous Labour administration.

If, as is expected, it views them as too optimistic, even harsher fiscal medicine will be required.

“The scale of what needs to be done is huge -- probably unprecedented in Britain,” said Julian McCrae, a fellow at the Institute for Government and a former government policy advisor. “It would be difficult in any circumstances, let alone this one.”

The budget deficit is running at just under 12 percent of GDP, not much smaller than that of Greece. While Britain has its own currency, which can buffer economic shocks, with economic growth sluggish few economists are betting on a return to robust tax receipts any time soon.

TAX RISES TOO

The necessity of compromise with the LibDems has already forced Cameron’s government to adopt a more redistributive agenda.

But Cameron is holding firm on a pledge that fiscal retrenchment should come primarily from spending cuts rather than tax rises, regarding an 80/20 split as the rule of thumb.

That has raised eyebrows among some commentators who question whether spending cuts on this scale are achievable, particularly given a commitment not to harm front-line services.

During the last fiscal squeeze in the early 1990s the then Conservative government aimed for a ratio of 50:50.

“The cuts to public spending look very deep and will be very hard to deliver,” said Carl Emmerson at the Institute for Fiscal Studies. “In the end it may be more tax-heavy than the Conservatives wanted.”

At a news conference on Monday, new Chancellor George Osborne made clear no tax rises had been ruled out and “very difficult decisions” lay ahead.

The government has already indicated its intention to raise capital gains tax on non-business assets. Value-added tax, which at 17.5 percent is lower in Britain than most other European Union countries, is another prime target.

PULLING TOGETHER

Bond investors, ready to pounce on any sign of fiscal laxity, have given an initial thumbs up to the coalition government -- Britain’s first since 1945.

Benchmark gilt yields have tumbled a quarter of a percentage point over the past week and the cost of insuring British debt against default has fallen.

Investors, who had feared a weak minority government could lead to fiscal stasis, have cheered the LibDems’ willingness to endorse an earlier start to spending cuts and a “significantly accelerated” pace.

But for all its tough rhetoric, the government’s stomach for unpopular measures will not be properly tested until its first budget on June 22.

At their first cabinet meeting last week, government ministers of both parties agreed to cut their own pay by 5 percent.

How easy it will be to impose cuts on other public sector workers remains to be seen. Unions are less strong in Britain than many other European countries but inflation is higher, running well above target at 3.7 percent, more than twice the level in the euro zone.

In the run up to the election, the LibDems argued that spending cuts should be postponed until the economy was stronger. Should the economy take a turn for the worse later this year, old wounds could be re-opened.

Editing by Mike Peacock

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