Of all the measures revealed by Alistair Darling designed to kick start the economy, the one that came under the most amount of flak was the cut in VAT.
Few people seemed to have been able to see any wisdom in the move at all. It won’t make a difference, they argued; who is going to be influenced by a 2 per cent odd fall in price? Meanwhile, retailers fretted over the cost of implementing the cut.
But, yesterday, the Institute of Fiscal Studies came out in defence of the measure: “The temporary cut in the standard VAT rate from 17.5 to 15 per cent is a better stimulus measure than its critics suggest,” argued the IFS.
Its reasoning is both sound and fascinating, but, even so, it seems the IFS analysis missed the point.
So, VAT has temporarily fallen by about 2.1 per cent. Not all goods carry VAT, not all retailers will pass the cut on, but the IFS assumed that the cut will lead to a fall in prices of around 1.2 per cent this year.
It appears that this is good for two types of individuals. For those of us who have a good credit record and savings, the cut in VAT will have what’s called a substitution effect. These people will realize that VAT will go up in future years to pay for the cut, so they will have an incentive to bring forward their spending now, when the economy needs it.
As for those who are strapped for cash and are not currently saving at all, the cut in VAT will quite simply mean their spending will go 1.2 per cent further. And since they are not saving, they will spend the money left over. This is called an income effect.
In fact, argues the IFS, the cut in VAT will have much the same effect on spending as a 1 per cent cut in interest rates.
If, however, the government chooses to keep VAT down next year, then the substitution effect will diminish. Consumers who save will have less incentive to spend more, because they will become used to the lower prices, and no longer see an urgency to spend before prices go back up.
The IFS says: “It is critical to bear in mind that the proper comparison is not between consumer spending now and last year but between spending now and what it would have been now in the absence of the tax cut.”
The reason why this comment misses the point, however, is as follows.
Do you really believe the key to getting the economy moving is to get consumers spending, or do you believe the problem is deeper then that, and that the structure of the economy had become too orientated to retail?
If you do, then the VAT cut does no more than encourage a habit that really needs to be kicked.
The money spent on the VAT cut would have been better spent on providing funding for businesses, especially start up businesses founded by people who had been unemployed, and it would have been better spent on improving the incentive to work and gain promotion via income tax cuts.
Economists say cuts in income tax don’t work that well, as people are more likely to save the money. But this misses the point too. The current tax regime acts as a disincentive to work and gain promotion. The ultimate way forward for the UK is to encourage people to work harder, and push to advance their own careers.
© Investment & Business News 2013