Cutting tax is not a zero sum game

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I’m cautiously optimistic about the rumoured plan of a 2.5% drop in VAT. It sounds like a good move to me, for several reasons.

One thing a VAT cut won’t do is lead automatically to a reduction in prices. Most food isn’t VAT-rated and it is hard to believe that a CD priced £9.99 this week will be priced £9.78 next week. However, taken together those 11ps start to add up. At the top end of the scale, being able to shave a bit more off the asking price for that plasma screen might just make the difference between whether it sells or not. If spending on the high street is down a couple of percentage points, dropping VAT by about the same amount could save real jobs. That means more people paying NI and income tax (and VAT) and fewer people claiming JSA. Looking it in that way, we have to ask ourselves the question: would it cost the Treasury more or less to keep VAT at 17.5%?

Gideon Osborne is not this blog’s favourite Shadow Chancellor, but I will give him credit for one thing: he has managed to get the media to completley buy into his claim that tax cuts now – any tax cuts – will automatically lead to paying a greater price in the longer term. The truth is much more complicated than that. VAT is a deadweight cost – a tax on commerce which is generally seen as a good thing. In my personal utopia, we wouldn’t have it in the first place. Dropping it at the start of a downturn has a real chance of softening the landing. It isn’t a magic feather, and there is certainly a point where the cost of dropping it outweighs the benefit, but it is a practical measure.

Vince Cable has broadly welcomed it, while emphasising the Lib Dem’s own policy for a tax switch (both policies are compatible). Cameron and Osborne have rubbished it. That should surprise no-one because VAT is the tax of choice for the Conservatives. It was Mrs T’s favourite tax. Raising it still further was one of Norman Lamont’s first acts as Chancellor. Ken Clarke, keen not to be outdone, expanded it to gas and electricity (Clarke has now come out as a VAT-cutter, suggesting his common sense now outweighs his dogma). Tory ginger group Direct Democracy – the closest the Conservatives get to genuine localists – envisage a world where council tax will be replaced by, you guessed it, a sales tax.

Once you remember that the Conservatives are not a pro-business party but a pro-entitlement party, it is easy to see why: piling the VAT on the proles means that you don’t have to pay for things by taxing unearned wealth. So for future Baronet Gideon Osborne to recoil at the merest suggestion is no surprise. The only tax cuts he will consider are on things like inheritence tax for millionaires.

The Tories have decided they are back in 1992, and have relaunched their “tax bombshell” posters. Labour should follow suit. Anyone remember VATman?

10 thoughts on “Cutting tax is not a zero sum game

  1. Scrapping VAT altogether might make a difference (and is a good idea IMO – now that would make a good European issue to fight the Euros on!)

    However a 2.5% cut is a bit meaningless. On a 37″ LCD TV (Price £749) you’d save about £16. The sort of amount that might make you chose a particular supplier as it’s the sort of thing you’d haggle over – eg get them to throw in a free bracket.

  2. Whether it gets passed onto the consumer or not is irrelevant. Either it does – in which case we get a bit more in our pocket – or it doesn’t (more likely in all but a few cases) in which case businesses make more profits.

    It all depends on how much the economy is set to decline by. If it is just by one or two percentage points, then a small VAT reduction is prudent.

  3. Cutting VAT by 2.5% is an utterly pointless measure – it is nothing like enough to stimulate spending in a deep recession when people are looking to reduce debt and will hit the Exchequer hard at a time when other tax receipts will be declining sharply. The fact is much expenditure would have taken place regardless of where the VAT rate is and so this income (some £12bn) will be lost unnecessarily. Inevitably some retailers will seek to repair their margins and not pass on the cut. Above all people will not feel personally any better off with such a measure.

    The real problem in this recession will be redundancies in the private sector and the direct loss of earning power by those immediately affected and by those who fear redundancy cutting back. Tax cuts should be aimed at slashing the employers payroll tax – the ridiculously named employers National Insurance (which is nothing of the sort) and substantially increasing personal allowances to take the low paid out of tax altogether.
    Although such measures could not be effected as quickly as the VAT cut, the knowledge that such tax cuts are in the offing should boost confidence and stimulate spending.

  4. We may well enter a “deep recession” but we are unlikely to do so in the next six months. Dropping VAT moderately when we are entering a moderate recession makes a lot of sense to me.

    And yes, certainly, NI (and Income Tax for that matter) are also good targets for tax cuts. I’m not arguing against that – indeed I fully support the Lib Dem’s funded proposals to do precisely that. But as you say it is less of a quick fix.

    Messrs Cameron and Osborne of course would have you believe that the only thing politicians should be doing right now is hiding under the kitchen table and hoping it will all go away.

  5. I certainly agree tax cuts are needed and I support our own Party’s funded proposals to cut N.I/ Income Tax.

    The VAT cut though seems to me to fail the cost/benefit analysis test. The recession also has a long way to go -the latest problems at Citibank are very concerning.

  6. I’m also slightly unconvinced by this. The reason politicians of most stripes tend to like VAT is that it is a largely invisible tax, people don’t realise they’re paying it and it provides a fairly stable source of revenue for public spending, even in recesssions. Conversely people really feel income tax rises and falls as it hits their take-home pay.

    The consequence of that though is that a cut in VAT will be largely invisible to consumers, particularly true with a falling pound, where many largely imported manufacturing goods will be more expensive. And also due to their being no VAT on essentials such as food.

    It doesn’t then stand as much chance of restoring confidence as a simple cut in the basic rate of income tax. People are more likely to spend more with extra real money in their pocket than with the prospect of fractional savings on marginal items they may be dithering over buying.

    The argument against an income tax cut playing at the moment is that it would simply be squirreled away in savings and not boost consumption. Evidentially there would be both a savings and consumption effect, but the attack on savings misses the point. This recession is largely due to a collapse of credit liquidity, lender confidence, and bad debt. One sure fire way of stabalsing the banks and increasing their confidence to lend then is to increase savings and investment.

    Healthy savings in the long run will also increase consumer confidence that they can afford to spend and create deposits for house purchases. Healthy investments will stabalise the stock market and improve business confidence.

    Liberal Democrat policy in this regard targeting cuts on income not VAT is much better than the mooted government proposal.

  7. But it is the indirectness of VAT that makes it less prone to Ricardian Equivalence. Now, that said, the current state of affairs (still high inflation, low interest rates, low confidence in banks) is likely to minimise the extent to which people will save an income tax cut, but it is still more prone to that.

    I’m not ultimately saying that a VAT cut is worse than an income tax cut. What I AM saying is that either proposal is better than the Tory approach.

  8. On the incoherence of the Conservative Party’s position I agree, I am somewhat puzzled by what they hope to achieve with these very anaemic and complex plans. Restoring consumer confidence and credit liquidity they will not.

    On the Ricardian equivalence point I’m not sure that is correct, and Ricardo rejected his own theory. But I’d be interested to hear an economist’s point of view on that.

  9. Interesting point, I’m not totally sold on the need for tax cuts – but I agree that the VAT route is the most direct way to stimulate spending. Indeed if it increases spending, it may even pay for itself while simultaneously helping the economy.

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