Could Tories and Lib-Dems really agree on the economy?

Financial markets were in bullish mood yesterday thanks to the 750 billion bailout of the troubled eurozone, so much so that the power vacuum in Westminster was merely a sideshow.

But it did not last long. Gordon Brown's last-ditch attempt to keep Labour in power sent sterling into reverse and the City into panic.

Nick Clegg must now decide who the Lib-Dems jump into bed with — a Conservative Party which fell just short of a majority or a leaderless Labour Party reeling from one of its worst ever defeats.

The view in the financial markets is clear.

A Tory-Liberal Democrat government led by David Cameron looks much stronger and more able to tackle the deficit than a "rainbow coalition" of Labour, the Lib-Dems and a host of minor parties including the Welsh and Scottish Nationalists.

It is unfortunate that power-sharing talks have been muddied by demands for electoral reform. If Britain really wanted proportional representation, why did the Lib-Dems get just 23% of the vote?

The biggest issue facing the new government is the economy, jobs and the shocking level of UK debt. The tragedy in Greece is a stark reminder of that — the City is crying out for deal soon.

There are lingering concerns that the Tories and Lib-Dems will not be able to agree on when and how to reduce Britain's record budget deficit of close to 12% of economic output.

The Lib-Dems sided firmly with Labour in arguing that Tory plans to start cutting borrowing immediately will put the economy at risk. Of particular concern was the Conservative proposal to make £6 billion cuts this year, to reverse much of Labour's planned rise in National Insurance.

Another sticking point could be how the fiscal squeeze is split between spending cuts and tax rises. The Tories favour a 4:1 ratio of cuts to tax rises, the Lib Dems 5:2, closer to Labour's 2:1.

There seems little prospect of the Tories agreeing to Lib-Dem proposals to raise capital gains tax, or scrap the Trident nuclear defence system. But these obstacles can be overcome.

All three parties propose to cut borrowing dramatically over the next few years, as the graph shows. The Tories want to start this year, the Lib-Dems and Labour next, but the end result is more or less the same.

The National Insurance debate was also something of a phoney war. The Lib-Dems want to scrap the "jobs tax" when they can afford it.

The £6 billion the Tories need to do so now is not a huge stumbling block, with borrowing at a record £163 billion a year and the national debt racked up by Labour heading towards £1.5 trillion.

To help plug the black hole in public finances, a Tory-Lib government could raise VAT to 20%. Both parties refused to rule out such a move before the election.

They could also combine plans to scrap the National Insurance increase with Lib-Dem proposals to raise the income tax threshold to £10,000. And a decision to shelve Tory plans to raise the inheritance tax threshold to £1 million could persuade the Lib-Dems to agree to immediate spending cuts.

The vast bulk of those spending cuts have yet to be specified, so there is room for manoeuvre here.
Jonathan Loynes of Capital Economics says: "It remains to be seen whether the parties can find enough common ground on issues such as electoral reform to form a government.

"But differences on the economy, and in particular the need and means to tackle the budget deficit, should not scupper the deal."