Thursday, 16 October 2008

Why cutting VAT could now be on the agenda

With the rise in unemployment figures released yesterday, and continuing long term downturn in consumer confidence affecting retail spending and small business, it may be that the time has come to consider cutting one of the most regressive tax schemes currently in place - VAT.

Calls have already been made this year for government to cut VAT on maintenance and home improvement work as a means to encourage homeowners to carry out energy efficiency measures and contribute to carbon reduction - see for details.

In his last speech as Chancellor, Gordon Brown also called on the EU to cut VAT on 'green goods' to 5%.

But a wider VAT cut may have advantages over tax rebate strategy that has been put in place by the Bush administation and which was echoed in comments made by the TUC's Brendan Barber in an interview with Channel 4 news last night.

As we highlighted earlier this year on this blog, one of the key theoretical advances made by the monetarist economist Milton Friedman was his exposition of the 'permanent income hypothesis' which dictates that households will not be encouraged to spend by income tax cuts whilst they are fearful for their jobs and long term position. As a consequence, VAT cuts have a distinct advantage - the benefits of them are only realised in the act of spending. To get the benefit of lower prices, you have to buy. They also have a real advantage in redistributing income to the poorest who spend a greater proportion of their income on VAT than higher income households, especially if the VAT regime is rebalanced in order to provide the largest cuts in the VAT rate on those goods which the poorest need and buy most.

If government is seeking to boost the economy and consumer spending then the measures we set out in our post earlier this week - an income based mortgage interest credit, central bank control over new long term mortgage and consumer lending rates, compulsion for banks to lend, discretion for courts to reschedule mortgages that are in arrears, and a cut in the VAT rate could form the basis of a solution.

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