VAT cut brings a Christmas sale for all – but will it work?

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Andrew Feinberg

White House Correspondent

Slashing Vat to its lowest level in almost 20 years is certainly a bold move. On one level, this is a well thought-out initiative, as well as being eye-catching. The economy needs more spending, so why not cut the biggest tax on spending? Assuming the retailers are as good as their word and pass on the cut, it ought to have an impact.

The problem with the alternative of reducing income tax – whether by lower rates, higher tax credits or more generous allowances – is that there is nothing to stop people simply saving the extra funds, so frustrating the fundamental point of the giveaway. This is exactly what happened with some of the tax rebates doled out by the Bush administration earlier this year in the US. It is also what has happened, frequently, to the Japanese, as they cut taxes again and again to liberate themselves from the incubus of deflation that attached itself to them after their property and stock market bubbles burst in 1990. Giving people an incentive to spend now is the key to the success of any fiscal stimulus; a temporary cut in VAT is the obvious thing to do.

The sort of reduction now on the cards – down to 15 per cent, from the 17.5 per cent level it has been levied at since 1991 – should inject about £12bn into the economy, or almost 1 per cent of the UK's gross domestic product. It is a substantial intervention. Indeed, next year could be a surprisingly prosperous one for many households. While worries about job security and house prices persist, some families will see an unexpectedly large boost in their disposable income over 2009. The reductions in interest rates being delivered by the Bank of England – and more will follow – will reduce monthly mortgage payments by hundreds of pounds for many families, especially those on tracker mortgages directly linked to the Bank rate.

Fuel and energy prices are already beginning to fall, which will reduce gas and electricity bills and the cost of filling up the car, and food prices should also moderate. And whatever tax cuts Mr Darling delivers are bound to increase households' spending power, as are even paltry pay rises when prices are stable. For the lucky ones, the increase in their income after tax and mortgage payments could be 5 or 10 per cent. Those in the public sector, just about the only area of the economy set to expand in the next year or two, are especially fortunate, for they can best take advantage of falling house prices. We may witness a small, silent revolution in the redistribution of wealth: while the investment banker, short of a bonus or even a job, may have to sell his luxury home, the university professor, confident the building society will recognise his security of tenure, may be in the odd position of being able to make an offer on it. We live in historic times.

The Bank of England has already said that there is a chance that inflation could turn negative next year; the reduction in VAT should knock roughly 1 percentage point off the price level, so increasing the chances of that unaccustomed event happening (for the first time since 1960, in fact). Would that mean a spiral of deflation? Probably not, if it is temporary. Depending on how long the VAT holiday lasts, it certainly gives the Bank of England more leeway to cut rates – and boost demand – in order to hit its 2 per cent inflation target, because it is in increasing danger of actually undershooting it. (The target is supposed to be "symmetrical".) Thus, interest rates too may fall even lower next year; the most extreme predictions are for rates below 1 per cent. These would be the lowest in the Bank's 314-year history.

Major shifts in VAT are rare, and are always deeply political. VAT arrived to replace purchase tax in the early 1970s as part of our preparations to join the European Union; levying VAT on sweets and the complications of the tax made it then an unpopular policy. By 1974, Labour's Denis Healey signalled his intentions towards the rich by imposing a special 25 per cent VAT rate on "luxury goods" – yachts and the like. When Sir Geoffrey Howe and Margaret Thatcher wanted to shift the burden of taxation away from incomes in 1979, they did so by (almost) doubling VAT, from 8 to 15 per cent on most goods. When Norman Lamont wanted to find a way to bring the spiralling cost of the poll tax under control in 1991, he opted to raise VAT. In 1994 the Tories tried, and failed, to introduce a massive rise in VAT on fuel bills, mostly reversed by Gordon Brown in 2001.

Now Alistair Darling has attached his name to cutting what has been a very unpopular tax. The danger is that its regressive tendencies will annoy Labour MPs almost as much as the abolition of the 10p rate did last year. Given that food and children's clothing are zero-rated, and fuel bills are 5 per cent rated, there will be no fall in the costs of these items, which take up a disproportionate share of the budgets of the poorest households. The showroom price of a Porsche, though, will drop by £1,000 or £2,000. And that should also remind us that much of the benefit of our increased consumption – if this cut in tax works – may leak abroad. Mr Darling could avoid this by making use of an obscure corner of EU law. According to Doug McWilliams of the economic consultancy CEBR, Article 28(6) of Directive 77/388/EEC permits a lower rate of VAT on labour-intensive services of 7.5 per cent. This would divert spending away from imported cars and electronic goods towards domestic hotels and catering, "cultural" activities, the labour cost element of home improvements, hairdressing and other services.

Cutting VAT, even temporarily, is expensive exercise and will lead to higher borrowing. Critics will say all it will do is bring spending forwards, and when VAT goes back up again, the economy will take another hit. That may be true, but the Japanese experience suggests that almost anything is worth doing now to avoid getting into the deflationary problems they found themselves in. By not acting rapidly and decisively enough – recapitalising banks, cutting interest rates, boosting government spending and cutting taxes – they soon found that almost nothing they did would work later on. Recently, they have told other G7 leaders about that lesson at every opportunity. So it's now or never. "There Is No Alternative" was once Mrs Thatcher's motto; today Tina will supplant Prudence as Mr Brown's companion.

VAT cut How it would affect the goods you buy

0%

No change in price on 0% VAT items

Non-luxury foods, books and maps, newspapers, public transport, children's clothing (except fur), caravans and houseboats, medication for the disabled

5%

No change in price on reduced rate (5%) VAT items

Domestic fuel, installation of energy-saving materials (insulation, solar panels), children's car seats, heating equipment, security goods (eg, locks, fire alarms), residential conversions, renovations and alterations, sanitary products

17.5%

Full rate 17.5% VAT items thought to be changing to 15%

*Ford Mondeo Current price: £15,995; new price: £15,175.26 Saving: £819.74

*John Lewis men's jacket Current price: £110; new price: £104.36 Saving: £5.64

*Clarks women's shoes Current price: £39.99; new price: £37.94 Saving: £2.05

*Bottle of wine Current price: £5.99; new price: £5.68 Saving: 31p

*Big Mac meal Current price: £3.79; new price: £3.60 Saving: 19p

*Tub of Ben and Jerry's ice cream Current price: £3.72; new price: £3.53 Saving: 19p

*Large latte from Starbucks Current price: £2.65; new price; £2.51 Saving: 14p

*Mars bar Current price: 40p; new price: 38p; Saving: 2p