Brown gets back on the political cycle

This was a tax and spend Budget with enormous risks. The chancellor has committed the government to large increases in public spending which will be very difficult to reverse. To pay for this, he is raising taxes by more than expected and relying on optimistic assumptions about growth. Interest rates will remain lower for longer, but if the economy grows more slowly, taxes may rise further.

The political cycle in taxation is alive and well. Last year's pre-election Budget cut taxes in the biggest giveaway since 1988. This year's post-election Budget reverses these cuts and more, dominated by the large increases in national insurance contributions. There will be modest tax cuts of £905m in 2002/03, but then taxes will rise by £6.11bn in 2003 and £7.64bn in 2004.

The City is also becoming familiar with Budgets that raise taxes by stealth and make the tax system more complicated. The chancellor was clear that national insurance contributions would rise by 1% for people earning up to £30,940 but buried in the detail was a new 1% tax above this ceiling.

National insurance was always a bad tax. The upper earnings limit on employee contributions means that the burden falls hardest on middle income earners. The wealthy with unearned income can avoid it altogether. Now this tax is worse. The new system creates two rates for employee contributions: 11% on earnings below £30,940 and 1% for earnings above. Remarkably, a New Labour government has reinforced a system that takes proportionately more from lower income households.

Audit

The winner will be the public sector, above all the NHS. This is also a gamble. There is little evidence that spending more money on healthcare improves the quality. The government will introduce an annual audit to ensure the money is spent effectively. This is welcome but it is hard to believe that money promised would be taken away, especially in the run-up to the next election.

The final gamble is on the economy itself. The Budget predicts growth of 2-2.5% this year, rising to 3-3.5% in 2003. The estimate of long-term trend growth has been raised from 2.5% to 2.75%.

These healthy numbers improve the fiscal arithmetic by several billion pounds a year. They are not unreasonable, but despite all the attention paid to strong retail spending and the booming housing market, the economy slowed sharply at the end of last year. GDP was unchanged in the final quarter of 2001. Consumers are relying on mortgage equity withdrawal to keep spending. It may not take much bad news for spending to slow sharply. Indeed, consumer confidence is already faltering again.

There are also risks from abroad. The worst of the global slowdown is over but it is clear recovery will depend on the US. The eurozone is being held back by inflexible economic policies and the legacy of German reunification. The weakness of the financial sector and falling prices are the main barriers to recovery in Japan. In the US there are doubts about the underlying strength of demand.

The business community will welcome the improved tax credits on research and development and the reduction in corporate taxes, especially for smaller firms. The chancellor made progress in reducing red tape by simplifying tax returns. Businesses face higher taxes too. Oil companies will face a windfall tax, which the stock market did not like. All businesses will pay more in employer national insurance - effectively, a tax on jobs - whether or not profitable.

Nervous

The good news is that the fiscal tightening in the Budget makes it less likely that interest rates will rise. The gilt market will be nervous about the fiscal arithmetic but welcome the prospect of continued low interest rates. The big issue for the City was whether this Budget would tackle the fundamental imbalances caused by the strength of consumer spending. The large tax increases for middle income earners will help. Even though they will not come in until April 2003, the fear of higher taxes was having an effect before the chancellor spoke. Moreover, the Bank of England takes a two-year view of inflation, so what happens in 2003 also matters for interest rate decisions now.

Experience suggests the Bank is twice as likely to change rates in the month of the quarterly inflation report. With the next report out on May 13, speculation about the timing of the first increase has focused on the monetary policy committee meeting concluding on the May 9. We believe the Bank's dilemma is unchanged and so interest rates will be too. Consumer spending is too strong but likely to slow, while manufacturing is too weak but starting to recover. The Budget points to interest rates remaining at current levels for some time yet.

· Julian Jessop is chief European economist at Standard Chartered Bank