The above quote is taken from a recent interview given by the Business Secretary, Vince Cable, who thus described the idea that tax cuts which could be used to stimulate economic activity could be implemented without a significant cost. He was responding to an interview given by the Shadow Chancellor, Ed Balls, in which he suggested that in light of the recent sluggish growth figures for the UK economy, January’s 2.5% VAT rise should be reversed, in an attempt to increase consumer expenditure, one of the largest components of aggregate demand within an economy, and thus to boost economic growth. However, whilst Tuesday’s figures were doubtless a little disappointing, I feel that to deviate from the plan set out by Chancellor would be potentially devastating for the country’s economy for several reasons.
Firstly, external affairs (e.g. the European debt implosion) are affecting the confidence of consumers and investors all the world over. For an economy such as Britain’s which is particularly internationally driven through its banking system, this is sure to spell trouble, at least until confidence picks up. This is the reason that the maintenance of international confidence in Britain’s economy is particularly important – and with the aforementioned European debt crisis threatening ever bigger economies (now including Spain and Italy), in conjunction with a potentially imminent U.S. default, the fact that the U.K. has a carefully spelt-out plan to deal with its debt in a systematic manner will count for more and more in terms of international confidence. But, by the same token, if Britain too is seen to be wavering, investors will look elsewhere, with crippling consequences for our economy.
Secondly, the notion of ‘cyclical growth’. This implies that an economy has a relatively fixed pattern of growth and contraction, which is the basis for the Keynesian theory that during the growth years, governments should build up a ‘fiscal surplus’ of income to spend during periods of recession, in order to alleviate the worst effects of the downturn and perhaps to decrease the amount of time spent in the economic doldrums. However, since the last government failed to build up such a surplus during their long period of growth, the national debt after the bank rescue and the additional spending associated with any economic recession has soared. We are now re-entering a period of (admittedly weak) growth, which means that we must use this time to attempt to regain some control over our budget deficit, and to use the money saved to begin to pay off our debts, before the economic cycle can come full circle again and we return to recession, and have to increase public sector borrowing to pay for additional contraction-associated spending.
Finally, let us not lose sight of the fact that, in spite of all the measures the Chancellor has taken, public sector debt is still increasing, with borrowing this year set to hit £122 bn. Whilst this represents a decrease of £20 bn. from the year before, this is by no means a trifling amount – and we are currently seeing all around Europe and in the U.S. the effects of high levels of national debt. It is probably only the fact that the UK had one of the lowest debt : GDP ratios among major developed economies (one of the few real economic achievements of the last government) which has saved us from this fate so far – yet we do not want to allow our debt to rise too much further, particularly as debt interest payments are already costing the economy an estimated £43 bn. per year, or 3% of GDP – money which could be spent much more effectively elsewhere.
This is all very well, say the Opposition, but they claim that a 2.5% cut in VAT would prove more beneficial to the economy than keeping the rate at 20%, as consumer confidence would be improved, and with it consumer expenditure, helping to increase the rate of economic recovery. However, I cannot help but feel this is somewhat a convenient halfway house for the Opposition; such a cut would see a reduction of only around 2% in prices for consumers, a reduction which would dissipate within months from the effects of inflation. And of course, the Labour party have ‘previous’ in this area – witness Gordon Brown’s cut in the same tax by the same amount towards the end of 2008. The move cost £12.5 bn. and was widely seen as achieving very little. However, by making such a suggestion, Balls and the Labour party can claim to be taking on the government’s cuts programme, without having to outline a genuine alternative.
Under EU regulations, VAT cannot be cut to lower than 15%, so the greatest cut that could be effected at the present rate would be 5% – a price drop of around 4% for consumers. This might be more useful, but would also be hugely expensive in the short-run. Perhaps a better idea would be the one Cable himself suggested to be under consideration in the interview – bringing forward cuts in taxes, including corporation tax, which are already scheduled for later in the Parliament, and then raising them again later. This would have an overall cost of zero to the government’s plan, as it has already been included in the scheme, and yet would have the advantage of allowing business to grow at this point in time to secure the recovery, which has not bounced back as the government expected.
Whilst this would incur a short-term cost, it could have long-term benefits, as expanding businesses take on more workers – thus increasing consumer expenditure without the need for a VAT cut. Furthermore, if it were made clear that the rate of tax would later increase again to compensate for the immediate cut, it would not be a true deviation from the government’s original plan, thus keeping the confidence of international investors – and avoiding suggestions of economic black magic.
By Duncan Sim
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