Monday, 22 December 2008

It's the Economy. Stupid!

A month ago, the British Government issued its "Pre-Budget Report" (a.k.a. a mini-budget that covers government spending). If you click on the link and look at the fourth item down, you'll see that from midnight on 30th November 2008, VAT was cut from 17.5% to 15% in an effort to boost the economy.

This VAT cut is the Government's main weapon in fighting the current recession. They estimate that it will add a £20bn stimulus to the economy. How?

The theory put out by the spin-doctors is that the cut will lower prices in the shops, consumers will stampede snapping up cheaper goods and thus spend the country's way out of Recession. Looks good on paper, doesn't it? But will it work? I don't think so.

(VAT stands for "value added tax". If the business is VAT registered (i.e. all businesses with sales > £67k), then they can reclaim the VAT on goods/services they've purchased by offsetting it against the VAT payable on the sales they make. Therefore, they only pay VAT on the difference or on the "value added" to the goods or services by their business. VAT cannot be reclaimed on purchases for private use.)

From the moment I heard it, I've been trying to figure out how it will stimulate the economy. And each scenario I come up with, doesn't work. Here's why:-
  1. It misunderstands the way business thinks about VAT because in virtually all businesses it is excluded from decision making calculations. Cutting it won't affect a multi-national's decision to build a new factory - that will be decided by the cost of the capital needed to fund the investment. And few banks out there are making money available to borrow at an affordable price. If the VAT cut offers any advantage, it is to cash-flow only since it slightly lowers the amount of cash businesses have to pay out to their suppliers and/or to the VATman. Even this, though, comes with barbs attached: for the first month or so, businesses will still be paying out VAT at 17.5% on invoices received prior to the cut-off but will only be able to recharge their clients/customers VAT at 15%.
  2. A 2.5% discount is useless at enticing consumers back into the shops when the 25%-50% discounts already on offer have failed. This response to the VAT Cut was raised by most political and economic commentators: consumers aren't shopping because they're worried about jobs, credit card bills, the price of fuel and mortgages. Cutting VAT won't affect that behaviour because it is only pennies - it doesn't put a lot of real money in our pockets. When your credit card is maxxed out and you are worried that you won't have enough money to buy petrol to get to work at the end of the month, the last thing you're going to do is go out and buy a new dress! This is the reality we are living with: the average Briton is carrying £4,000+ in credit card debt; mortgage interest rates are still rising, even though the Bank of England Base Rate has fallen to 2% (those on variable mortgages are paying close to 7% interest); in the past 9 months, the price of petrol and diesel increased by a third with knock-on price increases for virtually everything that is shipped by road. (FYI, for routes out of London, public transport is frequently more expensive than driving.)
  3. Where will the additional money go? Out of the Country. Whilst grocery items (food, toiletries, etc) are either made here or elsewhere in Europe, much of the "discretionary spending" items (clothes, shoes, household goods) are made in China, Vietnam, India, Africa, etc. If the consumer does go out and spend on nonessential items, they'll be purchasing cheap goods made in China or India and ultimately their purchases will benefit workers/investors in those countries and not here. Just as in the US with George Bush's Economic Stimulus Package, it will stimulate their economies and not ours.
For my £20bn, I'd like the Government to spend the money on something concrete HERE instead of exporting it to China. This country is crying out for capital investment: new roads, new railway tracks, a mainline rail hub at Heathrow, additional housing stock, a new storm-water drainage system for London (to stop effluent being washed into the Thames/flooding homes each time it rains for more than 10 minutes) etc. Why not use the £20bn to directly fund capital projects here???

Instead of funding public works, the Government is actually cutting them. An example: because the private companies involved can't raise capital, the Government has CUT the number of apartments that will be built in the Olympic Village to the minimum allowable under the IOC athletes' housing rules. This is in a country where we need an estimated 250,000 more homes just to meet current demand, in a city where the premium for new builds is still 100% over the cost of the build.

The lower rate of VAT will exist for 13 months. What worries me is that the VAT cut is short term but the long term costs will be with us for many years. To quote from the BBC
"..[The Shadow Chancellor]..George Osborne said the government's package of measures would double national debt to £1 trillion.

"He said this would leave "a huge unexploded tax bombshell timed to go off under a future economic recovery".

"He said Chancellor Alistair Darling was giving away £20bn but taking back £40bn through tax hikes."

Ouch! I've heard commentators say that it will take at least 20 years of tax rises to pay it back. In addition, the increase in National Debt will handcuff our economy, decreasing prosperity long term. It also makes us more vulnerable to economic and political shocks worldwide. Remember, he who owns the debt, calls the tune. (Don't believe me? Check out the Oscar nominated documentary: I.O.U.S.A. recently featured on the BBC.)

This is going to be an interesting few months, particularly if I'm proved right.

- Pam

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