George Kerevan: There's room for a VAT cut, which in turn creates cover

Published on Thursday 16 June 2011 21:41

THE economic news of the week was that British consumers have gone on strike. The Office for National Statistics (ONS) reported that retail sales in May dropped by 1.4 per cent compared with the same period a year earlier.

That was twice as bad as market forecasts - April had been an exceptional month thanks to Kate and Pippa Middleton shopping at Reiss.

A look at the fine print of the ONS figures is sobering. Consumers have to buy groceries, even if they come in smaller packets and cost more. So we are economising on big-ticket items such as household electricals and white goods. Tesco blamed lack of demand for electrical goods for its second consecutive quarterly fall in UK sales.

Enter the shadow chancellor, Ed Balls. Following the bleak retail numbers, Balls used his first big policy speech to offer a solution. He wants a temporary cut in VAT to boost consumer spending. He says cutting VAT back to 17.5 per cent, where it was before January, would have "an immediate impact" on family budgets.

This was a bold move. It also pointed up the dilemma faced by the real Chancellor, George Osborne. January's VAT hike, plus the unending squeeze from inflation, is slowing domestic growth. Yet the long-promised export boom is mortgaged to events in the eurozone and this week brought the inevitable Greek sovereign default a step nearer.

Osborne is keeping his fingers crossed that a combination of austerity and low interest rates will eventually right the economic ship. Meantime, retailers' shelves are piled high with unsold goods.

Balls's plea for a tax cut faced heckling from unexpected quarters. Tom Clougherty, of the free market Adam Smith Institute, accused him of playing "pure politics". In truth, the shadow chancellor got through his speech without actually telling us how to fund the VAT cut - presumably through borrowing.

There was also support for Balls. David Blanchflower, the former heavyweight member of the Bank of England's monetary policy committee, said: "Balls is right to suggest reducing VAT. It's reduced retail sales and pushed up inflation. Osborne has to act to mitigate his failed policy."

But would a tax cut actually boost retail sales or might hard-pressed consumers merely pocket the windfall to shore up their meagre savings accounts? We have some data from the US that indicates the latter course cannot be ruled out.

In December, President Barack Obama did a deal with the Republican Congress to boost flagging consumer activity. A series of income tax cuts originally introduced by George Bush were set to expire. Instead, Obama and the Republicans - to the chagrin of Democrats - agreed to maintain tax breaks for high earners in return for a raft of new measures to help the unemployed and low paid. The package gives the average US family an extra $2,800 to spend.

Six months on, US consumers seem to be saving the extra cash. Upper-income consumers in particular have pulled back on spending, puncturing the notion that they were bored with frugality.

On the other hand, a UK VAT cut would focus on the immediate problem - lack of consumer demand for manufactured goods. And it would insulate domestic growth from the coming eurozone disaster.

The problem is the cost - say 18bn for 18 months. The Office for Budget Responsibility reckons net borrowing will be 7.9 per cent of GDP this year, well down from 9.9 per cent in 2010. It should fall further to 6.2 per cent in 2013. This provides wriggle room to borrow a bit extra. As long as Osborne keeps net borrowing going down each year, the markets will be placated.

Instead, Osborne is relying on loose monetary policy. But low interest rates have ceased to have any impact over consumer spending. Base rates may be at rock bottom but bank lending remains anaemic. Annual growth in consumer credit is bumping along below 2 per cent. For the decade from 1995 to 2005, it was about 14 per cent. Which explains the lack of plasma screen sales.

On balance, there's much to be said for a VAT cut. And if you really want to live dangerously, reducing VAT could also provide political cover for an early interest rate rise. That would cool inflation and so boost real consumer incomes. It would also help savers and encourage banks to lend.

Yet I doubt if even Ed Balls is that bold.