Plan B is for bankruptcy: Ed Balls misses the point with his plan for a VAT cut.

The office for national statistics (ONS) revealed on July 26th that the British economy grew by an anaemic 0.2% for the 2^nd quarter; add this to the 1^st quarter’s 0.5% growth and the economy has grown a miserable 0.7% for the financial year.

Unsurprisingly, this has been jumped on by Ed Balls, the shadow chancellor, as evidence that the Tories are cutting, “too far too fast”. This is the typical labour chant on government economic policy and it is becoming almost as annoying as Tory ministers constantly bringing up the deficit to legitimise every government action[1].

It would seem therefore that both parties are often guilty of using the dyer state of the British economy to put forward ideologically driven remedies. One of the most consistent and vociferous defenders of the, “too far, too fast” camp is Ed Balls the shadow chancellor. He may feel vindicated by the figures published by the ONS, yet it may turn out that Mr Balls has mistaken a correlation for causation.

Mr Balls has long believed that reductions in government spending will prevent the economy from growing and that the conservative deficit reduction plan will lead to a contraction in demand and thus weak growth. So far, so left.  

Mr Balls’ solution? A reduction in VAT from the current 20% to 17.5%[2]. In order to understand why this is the wrong tool to fix the economy, one needs to look at the fundamental reasons as to why things are so bad.

Under Labour, the economy became dependent on consumer spending, public spending, construction and of course high finance and hence grossly unbalanced. Once the credit crunch hit and the tax revenues dried up from the city, government spending became unfunded. Consumer spending, once so strong, dropped off a cliff as access to easy credit evaporated along with consumer confidence. This was further exacerbated by the huge debts consumers had racked up on credit cards which would have stopped even the most profligate of consumers in their tracks. Finally, the housing market tanked, those individuals who believed they could always sell their homes at a profit found that they were now tied into high mortgage repayments for assets which were losing value.

This isn’t to say that the Tories would have done any better; it may be surprising to know that in 2006 the debt to GDP ratio was merely 55%, similar to Germany. It was the credit crunch and the brief premiership of Brown which truly messed up the public finances[3].

Reducing VAT, a tax on the price of stuff we buy, wouldn’t solve the mess as it doesn’t tackle any of the underlying problems highlighted above, it merely exacerbates them. Three main issues spring to mind:

1. A VAT reduction would encourage further consumer spending as products become cheaper. This is hardly desirable. Private sector borrowing, i.e. the amount we borrow as individuals when we buy cars, houses etc. is at 500%! Further increasing consumer spending would give a short term boost with long term ramifications, very much like the current ones.

2. VAT does not rebalance the economy. If the U.K economy is to grow then it needs to focus on selling its produce abroad. The reason for this is that the U.K consumer is, for lack of a better phrase, “maxed out”, whereas emerging markets have an expanding middle class just waiting to enter the world of consumerism. A reduction in VAT in no way helps make British firms more competitive abroad.

3. Finally, although the conservatives are guilty of bringing it into every political debate, the state of the public finances does require fixing. A reduction in VAT would have to be financed by an increase in taxes elsewhere, probably on income tax which is already at 50%, a level which is higher than France and double that of the U.S. Furthermore, a reduction in VAT could potentially send the wrong message to the markets at a time when they are very jittery about lending to governments. Thus Osborne has declared the VAT reduction plan as, “a plan for bankruptcy”, polemical but broadly fair.

Unfortunately, the frustrating truth for Britain is that slow growth may be the new norm. After years of excessive private and public sector borrowing, consumers and governments are in no position to increase demand. The lack of an export sector means Britain is unable to capitalise on emerging market growth. Expect a long slow recovery after the government and ourselves as consumers; try to shake off the debt hangover. A reduction in VAT won’t change that harsh reality.

The start of a miserable trend...

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[1] Most peculiarly, but somewhat impressively, a junior minister recently appearing on question time managed to bring the privatisation of forests into the debate over the deficit. Citing that although the conservatives didn’t want to privatise national parks they were compelled to due to the state of the public finances. The audience didn’t buy it but I guess it does show a commitment to the government line.

[2] Hence a product priced at £100 would go from £120 to £117.50 under Mr Balls’ plan.

[3] Thus as that old Etonian Prime Minister Howard Macmillan used to say in response to what undid his government, “events dear boy, events”. You can’t plan for a recession. Just like Cameron couldn’t plan for the phone hacking saga.