Sunday, July 26, 2009
Vat will surely rise to fill the Treasury hole
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


One story that will not go away is the dreadful state of the public finances. It will be around when politicians return in autumn for their party conferences, it will be the defining theme of the run-up to the general election, and it will dominate much of the next parliament.

What I want to do is first assess how much we really know about how bad things will be over the medium term. Then, given that all the emphasis has been on cutting public spending, I want to look at the inevitable tax rises that will accompany such a squeeze. What will they mean for the economy?

Alistair Darling has been criticised for not holding a review of public spending, a comprehensive spending review (CSR), to set out in detail government plans.

This would normally have been done in the summer and, while the chancellor said he will not leave voters in the dark about tough times ahead for spending, the Treasury argues that to set out detailed plans beyond 2011 would be a huge hostage to fortune.

That, of course, is politically convenient but is not indefensible. Look, for example, at how the prospect for the public finances has changed in the past 12 months.

Last week the National Institute of Economic and Social Research published its latest quarterly forecasts. As always, the NIESR's analysis was comprehensive and thought-provoking. On the public finances, it set out a couple of scenarios.

In one, public borrowing peaks at nearly 169 billion next year and then comes down gradually to a still-high 122 billion by 2013-14, but only if public spending is squeezed hard, with capital spending slashed and departmental spending cut in real terms. If not, borrowing stays high, only slipping to 160 billion, before which point the credit-rating agencies would have something to say about Britain's sovereign debt rating.

The NIESR is right to point out the dangers and the need for action. What is also striking is how wildly wrong assessments of the public finances have been. If we take NIESR's previous projections and everybody was in the same boat in January it expected a borrowing peak of 134 billion and a drop to 111 billion, even with a much gentler squeeze on spending.

In the summer of last year, before Lehman Brothers collapsed, a crisis figure for UK public borrowing would have been 70 billion. NIESR's July 2008 forecasts had it peaking at under 46 billion in 2010, before falling to 39 billion on the back of a modest fiscal tightening.

Given the dramatic changes in the numbers over the past year, we should be cautious about pretending we know what the budget deficit will be in four or five years.

In the 1990s, when Britain went from a budget deficit of 8% of GDP to a surplus in five years, even the Treasury was caught out by the pace of the improvement.

Policymakers have to plan for the worst, while hoping for the best. There is no doubt that in Treasury folders presented to the incoming government next year (blue for Tories, red for Labour, orange in case something really strange happens) big tax rises will be recommended, alongside the toughest squeeze on spending in the modern era.

We know from inadvertently leaked documents that last year the Treasury contemplated putting up Vat beyond 17.5% some time after the temporary cut to 15% runs out at the end of this year. You can bet a Vat rise will be among official proposals.

A Vat hike to 20% would raise a decent annual amount, 12.5 billion, would give us a neater tax system (20% income tax, 20% Vat) and be compatible with rebalancing the economy away from the consumer. It would be bang in the middle of the EU range, 15% to 25%, for main rates of Vat.

There are also arguments against. At the margin, it would increase the incentive for people to operate in the black, or "cash" economy. Any tax rises are unwelcome.

The Tories, who have form on Vat, raising it in both 1979 and 1991, have not said anything yet. The nearest thing to a broad hint of where indirect tax rises might come is that they will be used to promote greener behaviour, which implies higher duties on petrol (always a bit risky) and other environmentally unfriendly products.

The trouble is there are few taxes that generate big money, Gordon Brown having used up most of the "stealth" options. The big taxes are Vat, income tax, National Insurance (NI) and corporation tax. A small (0.5%) increase in employers' and employees' NI in 2011 is already planned. Nobody would want to raise the main income-tax rate, though Labour might seek to reduce the income level (150,000) at which the new 50% rate comes in.

Let us suppose Vat is the centrepiece of a tax-raising strategy that brings in, say, an additional 20 billion a year, a figure recently floated by the Centre for Economics and Business Research. The rest could come from a 1981-style freeze on personal tax allowances and a range of smaller measures, including some with a green tinge.

How quickly would you want to introduce such a tax rise and what effect would it have? A new government would prefer to get the bad news out of the way quickly with an emergency budget, and show it meant business on the public finances.

The trouble is that a summer 2010 Vat rise to 20% would mean two hikes in a year, with the rate already going back up from 15% to 17.5% on January 1. In general, while it is good to announce tax rises quickly, it probably makes sense to spread them over two or three years.

This is what the Tories did in 1993, using two budgets that year to increase the level of taxation by the equivalent of much more than 20 billion, but spread over the following three years. Not all the additional burden fell on individuals but quite a lot did, including a 1% NI increase, a freeze on personal tax allowances and over-indexation of petrol duties.

Famously, tax increases did not prevent economic recovery, though it made voters more disgruntled. Consumer spending had one bad year as tax rises came through, growing only 1.4% in 1994, fortunately a year when exports and investment grew strongly. Otherwise, spending grew pretty well, 3% in 1993, 2.6% in 1995, 3.1% in 1996 and an exuberant 4.2% in 1997, which sadly for the Conservatives did not help during the election that year.

History may not repeat itself, for all sorts of reasons. Higher taxes do not, however, necessarily knock growth on the head.

PS: Is it a case of farewell quantitative easing, we hardly knew you? Before the July meeting of the Bank of England's monetary policy committee (MPC), the City expected a further 25 billion of purchases of assets, mainly gilts, to take them up to 150 billion. Then the Bank would put in a request in August to the chancellor to extend purchases beyond the previously agreed 150 billion limit.

But there was no such decision at the July meeting. And now, after minutes from that meeting showed a unanimous vote not to extend quantitative easing, people think the Bank is done. That may not be quite right, particularly after disappointing second-quarter GDP figures. Andrew Sentance, an MPC member, said that even a continued pause in August would not preclude the Bank resuming the policy if it believed the economy needed a further injection.

What the Bank also did was to remind the markets that what matters for quantitative easing is the stock of assets purchased, not the process of purchasing them. Analysts had believed it would go on buying at 25 billion a month until evidence of recovery was incontrovertible. The Bank's view was that it was important to buy the gilts, and quickly. Then it could wait for the normal lags in policy to kick in and for the boost to come through fully. That, barring further surprises next month, looks to be more or less where the Bank has got to.

From The Sunday Times, July 26 2009