The cost of living crisis isn’t going away. People are feeling the pinch, and policymakers are looking with alarm at forecasts of inflation hitting 10% or more this autumn. The idea of a single intervention that both puts money in people’s pockets and also cuts headline inflation is therefore very alluring. Hence the calls for a temporary VAT cut coming from Downing Street, some Conservative backbenchers and the Liberal Democrats. 

You can understand the appeal. At £18bn, a 2.5% cut in the top rate of VAT injects enough funds into the economy for people to notice. Superficially, the timing is right because the economy appears to be slowing down in real terms – there have been signs of growth tailing off to around zero. Retailers would normally pass most of any cut through to shop prices, so ordinary households benefit. The prime minister and chancellor get to deliver on their promise to cut taxes. What is not to like? Unfortunately, the answer is: plenty.

Stimulus is not an answer to inflation

A VAT cut is a broad-based stimulus – the equivalent of sending a cheque to everyone in proportion to how they shop, roughly speaking. Just because it manifests as prices being lower than otherwise does not change this. And the message of high inflation is that the economy does not cry out for more stimulus. Demand has been outmatching supply. If this was only about energy prices, then the Bank of England might be more relaxed – and the government could restrict its response to the energy sector alone. But OECD figures show that around two-thirds of items in the CPI basket are rising in price at over 4% a year. A further fifth are rising at over 2.5%. Meanwhile, the labour market is as tight as it has been this century, in terms of the numbers of workers available for each job vacancy.

Stimulus is not an answer to inflation, no matter where it ends up. Moreover, businesses struggling to find the staff or pay their bills are less likely to pass on a VAT windfall than they would during times of low demand, such as when VAT was (correctly) cut in 2009. This is just one reason that the inflation-cutting attractions of a VAT cut are not that great either. Another is that when the headline figure is likely to hit double figures, it is fanciful to think wage demands will be substantially moderated by a slight change in the number. The difference between 2% and 4% inflation is much more noticeable than between 8 and 10. 

A temporary VAT cut will be politically problematic

If the aim is to reassure that inflation has not become de-anchored from people’s expectations, then a temporary cut is also a problem. When the VAT cut expires, whatever price-lowering effect it might have had at the outset is likely to be reversed, causing headline inflation to rise again. While it may lower the peak rate, this means it may mean headline inflation staying higher than its range for longer. 

The temporary aspect is a problem for another reason. How credible is it that a government facing a general election will stick to a promise to raise taxes by returning VAT to its previous level? The Treasury must be at least a little concerned that the prime minister will lobby to keep lower VAT in place, thereby continuing to pour stimulative fuel on the fire. 

A possible counter-argument is that extra stimulus is no particular problem, so long as the Bank of England is free to react and raise interest rates more. This is technically true – there is no limit to the Bank’s powers to slow down the economy, just as there is no ceiling on the base rate. 

This is not the same as saying the Bank would welcome the challenge, however. The more stimulus it has to counteract, the more risk there is of a mistake – the Bank tightening so much there is a recession, or falling behind and letting inflation really let rip. 

And I doubt it is the Treasury’s preference either. It is reasonable to argue that a mixture of tighter monetary and looser fiscal policy is a better combination for the UK than what it has experienced since 2008. But with government liabilities highly sensitive to short term rates (thanks to QE), just one per cent higher rates leads to a £21bn higher deficit, which will have to be closed somehow.  

For a while it was natural to accuse the Treasury of crying wolf about the risk of a serious debt crisis. But picture this: a VAT cut at risk of becoming permanent, in the face of intense pressure from parliament; interest rates rising faster than expected just last March; inflationary expectations becoming more unanchored as consumers are given the message that the government wants them to shop; and a winter fuel crisis with spikes in the price of unobtainable gas. Maybe this is not the likeliest outcome. But governments need to act with the worst outcome in mind. Sometimes the wolf does indeed rush out of the woods. 


Original source – The Institute for Government

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