Why the VAT cut won’t work

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An economist of my acquaintance sent me the following note. With his permission I reproduce it:

There is a good deal to be welcomed in the pre-budget report, not least the general recognition of the scale of the problem that the UK faces, and a clear willingness to spread the burden across the income distribution. However, in cutting the VAT rate, the Chancellor has made a simple and important error.

We - and our policymakers - are accustomed to think of economic management in terms of marginal effects. If we increase by one per cent here, and cut by one per cent over there, what impact can we obtain?

One orthodoxy of this approach has been that the marginal effects associated with the top rate of income tax are so large that it would be foolish even publicly to consider increasing this rate. If this Government are returned at the next election, I suspect their planned increase of the rate - to 45 per cent for the top one per cent of income earners - will see this orthodoxy exposed as fallacious. There will be no grand exit of our higher earners, no sudden leap in avoidance and/or evasion activity, and no appreciable dent in economic activity.

There is also a great deal to be said for, and little to fear from starting to take steps to ensure the UK's crown dependencies and overseas territories meet their responsibilities in a world of globalised finance. The secrecy and regulatory arbitrage which many of these jurisdictions have provided, along with a good many others, have played a major role in causing the crisis itself. As long as action sits within broader multilateral action to address this global problem, UK leadership here may even work ultimately to the benefit of these jurisdictions. With their clear role in the crisis, and the election of Obama in the US, there is no question that change is coming. Those secrecy jurisdictions which embrace it and move first may well find that this is ultimately to their advantage.

The worry with the VAT cut relates to the model of consumption on which it is implicitly based. It appears that the Chancellor has a simple model of supply and demand in mind. By reducing the price of VATable items by 2.5 per cent across the board, his thought is to reduce the price paid by consumers (while protecting the price received by retailers and producers). This, it is hoped, will simply increase consumer demand (marginally) at any given pre-tax price, moving us to a (marginally) higher consumption equilibrium than would otherwise have occurred. As you note Richard ('The impact of the VAT change'), the Chartered Institute of Tax estimates the impact on households earning £20,000 a year will be £2.50 a week.

This is a policy for marginal adjustment, which would make sense if the problem were - as it has been during most of New Labour's reign - simply one of gentle demand management. If we envisaged 99 per cent of the economy being unchanged, and were looking simply to increase consumption a little to make up for some problems in the other one percent of the economy, then this would be appropriate - even too powerful, perhaps.

We are not, however, facing such a situation. We are not in a position to focus on slightly increasing the exact amount of consumption expenditure of otherwise stable, earning households.

Instead, the UK faces the risk of large-scale unemployment. In consumption terms, this means the risk of multiple households moving from consuming, say, 70 or 80 per cent of their income in 2007, to consuming all of their income in 2009 - but where that income is perhaps only 20 or 30 per cent of what they received in 2007.

For the national economy, the consumption implications are unlikely to be marginal. The US economy, which as the home of the subprime crisis is somewhat ahead of the UK on the recession path, saw personal consumption fall at an annualised rate of 3.7% in the third quarter of this year.

This means that the Chancellor's VAT cut will only prove sensible if the immediate consumption effects are sufficient to prevent much employment from occurring - in other words, to intercept the economy on the recession path and move it onto a different trajectory.

While this is not absolutely impossible, it seems extremely unlikely. Households have moved into a different phase, for they are not oblivious to the crisis in financial markets and nor are they able to access credit in the same way as they could even last year, so a small price cut will not have such a great effect.

The real problem is this. Small businesses are an important provider of employment, especially when large firms are laying off staff. But nothing kills a small business like unemployment - it is not a question of finding the right deal to attract people, of cutting prices or changing advertising, for example. It is simply that people do not have the money, and therefore cannot buy your goods or services - and that is the end of the small business.

When such a fall in demand combines with a sudden and sharp drop in the availability of working credit to business - and the smaller firms are systematically hit the hardest during such phases - the outcome can be dramatic.

This is also the reason why annual mortality rates during the last serious recession of 1990-92 were highest among smaller firms, and why - unless action is taken to stem the first round effects of rising unemployment now - there will be a serious multiplier effect on unemployment as greater numbers of small businesses go to the wall.

To highlight just one social impact of this, as the government have done, we might consider the impact on child poverty. Addressing the extent to which local authorities fund schools with poorer intakes is laudable, but if widespread unemployment condemns their parents to years on benefit then surely any impact is likely to be completely subsumed.

The UK does not need a VAT cut to induce a little more consumption from those who can. What it needs, apart from measures to protect the supply of working credit to smaller businesses, is a serious effort to combat the incipient rise in unemployment.

That means government identifying the most beneficial way in which to employ people for the public good - which as you and Obama have suggested, Richard, seems likely to include a good deal of green investment. The multiplier effects from providing incomes to those who would otherwise be unemployed will be far greater than that of marginal increases in spending power for those with relatively stable incomes.

And if the same employment can help us to ensure global greenhouse gas emissions peak by 2015, as is almost certainly necessary if we are to obtain 80% cuts by 2050 and so avoid the potentially irreversible warming process that could follow if we go beyond 2¬?C, that looks like pretty good value for money to me.

If the UK government hasn't yet moved beyond an approach focused on marginal effects, then they urgently need this to be pointed out - by opposition, by their own MPs, by the electorate, by media commentators and by civil society groups. The pre-Budget report has much to recommend it, but the next Budget must show an analysis that reflects the current economic times - or history will not forgive the marginal managers.