Q Does Alistair Darling tax cut put the Government’s financial rules in jeopardy?

A Yes. The Chancellor’s decision to borrow £2.7 billion extra in 2008-09 adds to already big question marks over his finances, and over the two fiscal rules out in place by Gordon Brown as Chancellor.

Q What are the rules and what strictures do they impose on the Chancellor’s freedom of action?

A The first rule, called the “golden rule”, requires that the Government pays for all day-to-day spending - other than investment on infrastructure like roads, and hospital buildings - out of tax, and not by borrowing.

The golden rule says borrowing should only be used to pay for investment, to ensure that the government is fair to future generations and doesn’t borrow to splurge on the generation of voters at the expense of the next.

The second rule, the so-called “sustainable investment rule” says that whatever the Chancellor borrows each year, the total of any borrowing to be paid back, the national debt, should be kept under 40 per cent of national income (GDP).

Q So by borrowing to cut taxes, as he did this week, Mr Darling must have broken the golden rule? Tax cuts are not investment, are they?

A Tax cuts don’t count as investment. But crucially, the £2.7 billion extra the Chancellor is borrowing does not break the rule because this is judged over a full economic cycle, which can last an indefinite number of years. So borrowing can be used to pay for for day-to-day, non-investment spending in individual years, so long as this is offset in other years in the same cycle.

The Treasury expects to have to borrow this year to pay for day-to-day government spending as it will have too little tax to cover this. This will leave it in the red on its “current budget”.

But this won’t break the golden rule so long as the current budget stays in the black in future years of the economic cycle that is says is just starting. To achieve that, taxes raised will need to be bigger than day-to-day spending in those coming years, creating a yearly surplus.

Q Will this happen now?

A The Chancellor expects to be in the red on the current budget this year and next, and then to return to, and stay, in the black. On his forecasts, current budget deficits totalling £14 billion this year and next will be offset by surpluses of £33 billion in the following three years.

Yet there are problems. Many economists believe that the Chancellor’s will be in a markedly worse financial position as a weakening economy hits tax payments. So if deficits mount up faster and for longer than Mr Darling hopes, he could break the rule. To that extent the £2.7 billion extra borrowing announced this week adds to his headache.

The good news for the Chancellor is that none of this will happen this side of the next election as the cycle rolls on toward an indefinite end we don't yet have a date for. After an election, taxes could have to be raised to prevent the rule being broken.

Q What about the sustainable investment rule?

A This is at greater risk as past heavy borrowing has seen the national debt rise close to Mr Brown’s ceiling of 40 per cent of GDP. Debt is forecast to be 38.5 per cent of GDP this year, and 39.8 per cent by 2010-11 - just a whisker off the ceiling.

So the £2.7 billion in extra borrowing, worth 0.2 per cent of GDP, would take Mr Darling up to the ceiling in 2010 - unless he makes offsetting measures, raising taxes or cutting some spending in his November or spring budget statements, as he has committed to do.

Q Does this matter for the economy?

A Not really. Most economists agree the main importance of the rule is on the Government’s financial credibility with the markets and its political credibility with the voters. It is designed to make the Government look prudent.

Breaking it would leave Mr Brown and Mr Darling red-faced. But there is no particular reason for debt to be kept at 40 per cent and many countries have much higher national debt totals with few problems.

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