Should Philip Hammond cut VAT to support post-referendum economy?

Jake Cordell
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The scissors are in the drawer - will Philip Hammond take them out?
The scissors are in the drawer - will Philip Hammond take them out? (Source: Getty)

Theresa May and Philip Hammond have promised to "reset" the government's spending plans in the wake of the EU referendum.

George Osborne's goal to run a budget surplus has been abandoned while rumours about a massive injection of government spending are gathering pace.

In 2008, as the Labour government scrambled to deal with the start of the slowdown, chancellor Alistair Darling announced a temporary cut to VAT in a bid to support consumer spending and make sure the economy did not grind to a halt.

Could a similar measure be on the cards this time around, and how helpful would a cut to VAT be?

VAT: The politics

Cuts to VAT have significant political capital both because it is an easy to grasp concept and can deliver a direct and immediate affect on everybody in the economy.

The Bank of America Merrill Lynch's chief European economist Gilles Moec summed up the benefits: "A VAT cut gets through to households quickly ... is technically simple and easy to communicate."

"When it comes to taxes, VAT cuts are the best way to help low and middle income families," said Andrew Harrop, general secretary of the Fabian Society.

"VAT is regressive in nature: It hits poorer households harder because consumption makes up a much larger share of their disposable income," said Michael Martins of the Institute of Directors (IoD).

"The new chancellor faces a delicate balancing act: He may find it difficult to cut corporation taxes for 'big business' while leaving consumption prices the same," he added.

VAT: The economics

However, the economic case for cutting VAT is slightly harder to gauge.

Tax receipts from VAT make up more than 17 per cent of the government's income, so even the smallest change has a big impact on the public finances. They are third only to income tax and national insurance as a source of cash for the government.

"One problem is that it costs quite a lot to make a meaningful cut in the VAT rate," said Capital Economics' Scott Bowman.

In a note issued this morning, the Bank of America Merrill Lynch said slashing VAT from 20 per cent to 17.5 per cent would push consumer prices down by one per cent. This would completely offset the inflationary impact from the falling value of the pound for around 12 months, it suggested, while costing the government about 0.7 per cent of GDP in lost tax revenues.

On the wider economic impact, a cut of just one percentage point - from 20 per cent to 19 per cent - would still cost the government 0.3 per cent of GDP, according to Bowman, but would only boost the size of the economy by 0.1 per cent - a return of one pound in growth for every three lost in tax revenues.

Additionally, Bowman points out evidence on whether VAT actually boosts spending are mixed, with a PwC survey showing than fewer than one in eight shoppers changed their spending as a result of Darling's cut in 2008.

Former business secretary Vince Cable is an advocate. He told City A.M. he believes VAT cuts are "the most effective way of influencing consumer behaviour in the short-run". However, he cited that the bigger problem facing the UK economy is "uncertainty over investment, rather than consumption", hinting its effect alone might be more limited.

VAT: The alternatives

When stood up against other potentially contradictory or complementary measures the issue of whether or not to cut becomes even trickier.

"Certainly a VAT cut would be a much better way of stimulating the economy than a big stimulus package from the Bank of England," points out Shanker Singham, director of economic policy at the Legatum Institute think tank.

While Threadneedle Street is preparing to slash interest rates and potentially boost its quantitative easing programme next week, its top officials have warned markets neither will provide the big immediate impact that might be hoped for.

As consumer spending is expected to hold up better than other areas of the economy, such as construction and business investment, economists suggested it might make more sense to focus on the worst hit areas.

"The government could incentivise business investment," said Capital Economics' Bowman. "This could include a further cut to the corporation tax rate or an increase in the annual investment allowance.

"Or the government could take advantage of record-low gilt yields by borrowing to invest in infrastructure". Figures from the Office for Budget Responsibility (OBR) imply that while a VAT cut might deliver 30p in economic output for every £1 it costs the government, direct spending on investment can deliver a one-to-one return in the short-term.

Depending on how loose the new top team of May and Hammond are willing to be, these options need not be mutually exclusive. "A VAT cut versus a stimulus package, like quantitative easing, are two very different approaches," said Legatum's Singham.

Singham added, however, that while any form of stimulus can stabilise economies in the short-term, "it is as best a band aid, and [in the past] has not led to the long-run economic growth that the UK and global economy needs."

VAT: An Autumn move?

As to whether or not Hammond will choose the VAT route, consensus seems to suggest it is definitely an option, though by no means top of the list.

"A cut in VAT would seem unlikely at a time when the new chancellor is likely to pursue an accelerated reduction in corporation tax and increased fiscal stimulus on things like infrastructure projects," said Martins of the IoD.

Weighing up the probability, Capital Economics added: "We think a cut in the rate of VAT in the Autumn Statement is a possibility, but we don't think it is particularly likely."

Read more: What now? The UK and the Single Market

One other thing is worth remembering. Until the UK formally leaves the EU, it is only allowed to cut its VAT rate to a minimum of 15 per cent, and is still bound by the rules on things like the reduced and zero-rated goods.

Osborne had his fingers burnt trying to tinker with the rates. Hammond will be sure to want to avoid his own Pasty Tax moment.

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