Not easy to make the case for tax cuts

When growth in the economy is sluggish, as it plainly is, it is natural to think of ways of doing something to boost it.

And, when interest rates are already at a record low of 0.5%, and the Bank of England has already pumped £200bn into the economy through asset purchases or ‘quantitative easing’, it is natural that thoughts turn to tax.

Cutting the rate of VAT?

Almost from the moment the coalition government increased VAT from 17.5% to 20% in January, Labour has been calling for its ‘temporary’ reversal.

Ed Balls, who let it be known he thought even the deficit cuts planned by Alistair Darling went too far but has since towed the party line, has been leading the charge.

On the face of it he has a point. Consumer spending is one of the economy’s undoubted weak spots.

Its failure to recover is the biggest single reason for the economy’s subdued recovery. Surely a VAT cut would help?

 It might, though only at the margin. If we look at why consumers are not spending freely, two factors jump out.

The first is that people remain wary of the economic outlook, including their own job prospects.

The second factor is that household incomes are squeezed.

Last year saw the biggest fall in real incomes since the 1970s. This year will see an unusual second successive annual fall.

The rise in VAT is one reason for this squeeze on real incomes but it is only one, the others being higher food and energy prices, as well as the impact of the low pound on a range of import prices.

Reversing the VAT hike would ease that squeeze a little but not remove it.

The central point is that the VAT hike was a key component in the government’s deficit reduction programme, more certain in its impact on the public finances than public spending cuts.

It is worth roughly £12.5bn a year, at a time when the budget deficit appears to be coming down more slowly than hoped.

So, the case for reversing the hike has to rest on one of two things.

Either room for fiscal manoeuvre has suddenly opened up, which it has not, if anything the opposite has happened.

Or, a cut would pay for itself, generating enough additional revenue as people spent more to compensate for the direct loss of revenue from cutting the rate.

Anything is possible but this is highly unlikely.

Research in this area suggests there would be some compensating increase in spending but not nearly enough.

A VAT cut would add to the budget deficit, undermining the government’s efforts to bring it down.

What is true for VAT is also true for most other taxes.

The costless tax cut, certainly in the short-term, is a rare as hen’s teeth.

Behaviour may change over time in response to lower taxes but, in general, the lags are too long for a government committed to cutting the deficit.

The 50p rate

Could the top rate of income tax be the exception that proves the rule? The new 50% top rate of tax, which came into force in April last year, is politically divisive.

Labour introduced it before leaving office, insisting it was doing so more in sorrow than in anger, but also insisting that everybody had to share the burden of getting the deficit down.

That chimes in with Osborne’s famous ‘We’re all in this together’ catchphrase, though under pressure from his own party, he has made clear that he would like to see the back of the 50% top rate as soon as possible.

In this, however, he has at odds with his coalition colleagues.

The Liberal Democrats have made clear that, not only are they philosophically opposed to cutting the top rate (for years a 50% rate was party policy) but that there are many other priorities.

In particular, they favour taking more people at the lower end of the earnings scale out of income tax altogether, by raising the personal allowance further.

 One suspects that, if it came to it, the Liberal Democrats would prefer Labour’s VAT cut to the Tory ambition of cutting the top rate.

 So are we stuck with the 50% rate? As readers will know, the chancellor asked HMRC to investigate whether the 50% rate is a net revenue raiser.

Has it, instead, led to such an increase in tax avoidance that its impact on revenues has either been neutral, or even negative? If that were the case then, despite the political sensitivities, it would make no sense to keep it.

The HMRC exercise will not be ready for a while.

It cannot be carried out until, at the earliest, all the self-assessment data is in at the end of January.

Even then, that would comprise only one data set, which wise officials would no doubt argue is not enough on which to base such an important decision.

So, while action on the top rate in the March budget is possible, that looks rather early.

It may be, of course, that the evidence Osborne is looking for is not there.

A tax that raises no net revenue, albeit one introduced by the previous government, would look amateurish, something HMRC and HM Treasury will not easily admit to.

At the time it was introduced most tax specialists, even if they did not welcome the tax, noted that one of the most obvious loopholes – putting a higher proportion of salary into pensions – had been closed.

Though there is plenty of anecdotal evidence that the 50% tax had had a negative effect on revenues, those looking for it in the HMRC’s analysis may be disappointed.

As always, there are no painless answers on tax.

It may be that we have to wait quite a while for genuine tax cuts.

David Smith,  Economics Editor, The Sunday Times