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Tom Clougherty: Ed Balls’ suggestion of a temporary VAT cut is pure politics - and bad economics

Tom Clougherty Tom Clougherty is executive director of the Adam Smith Institute.

The Adam Smith Institute is well known for advocating lower taxes to encourage economic growth. So perhaps you’d expect me to be happy that Ed Balls had come around to my way of thinking, and proposed a tax cut to stimulate the economy. Well, you’d be wrong. Ed Balls’ suggestion of a temporary VAT cut is pure politics, and bad economics to boot.

First of all, it is very unlikely that a policy of temporary tax cuts coupled with higher spending would do anything whatsoever to boost confidence or stimulate the economy. People aren’t fools – they know that you can’t just borrow more, spend more, and raise less without it coming back to bite you. People would see Balls’ reckless fiscal policy for what it is – a threat to economic stability – and batten down the hatches accordingly.

They’d probably be right to do so. Despite all the talk about deficit reduction, the government will still borrow in excess of £120bn this year. As such, any policy decisions that would increase the deficit further risk precipitating a sharp, sudden rise in interest rates, as gilt investors lose confidence in the government’s ability to meet its funding obligations. That could push millions of Britons into financial distress, and conceivably trigger a fresh banking crisis as people start to default. Such a scenario is a far bigger threat to the economy than the lax consumer spending Ed Balls is worried about.

Furthermore, there is no reason to believe that Britain could not be plunged into a full-blown sovereign debt crisis if the political commitment to deficit reduction was called into question and spending once again spiraled out of control. If it came to that, we would be forced to make much deeper, sharper cuts than the coalition government is planning. And that shock treatment would be far more painful than the modest 0.7 percent a year cuts that are currently on the agenda.

Even taken on its own terms, and ignoring the broader fiscal context, the idea that a temporary VAT cut would stimulate the economy in any noticeable way is not convincing. Indirect taxes like VAT have a far less pronounced effect on behaviour than direct taxes on work and investment. Assuming that a VAT cut would deliver a big short-term boost to consumer spending is, therefore, rather wishful thinking. This is compounded by the fact that temporary tax changes rarely have much impact on people’s spending habits – it is only permanent changes in income that seem to significantly affect consumption.

Even then, there’s a further point to be made. Let’s say that Balls’ temporary tax cut did succeed on its own terms, and got consumers spending more money. It is not at all clear that this would be an entirely good thing. British households are so indebted that a period of lower spending as people pay down their debts and rebuild their savings is probably necessary if the economy is going to return to real, sustainable growth – and not just plunge headlong into another series of credit-induced bubbles.

Essentially, then, the shadow chancellor has proposed something that is highly unlikely to succeed on its own terms. Even if it did, it’s not clear that that success would be a good thing for the economy. At the same time, his have-your-cake-and-eat-it too approach could easily damage confidence, rather than boost it, and destabilise the economy, rather than stimulate it. In short, it’s about as far away from a genuine recipe for growth as you can get. Or to put it another way, fiscal stimulus is just a load of Balls.

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