Why an autumn tax hike would be a terrible idea for the U.K. economy

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Rishi Sunak, the British Chancellor of the Exchequer, is about to announce both tax cuts and tax hikes. This may sound bizarre, although they wouldn’t happen at the same time. First, a cut in the value-added tax rate, to stimulate consumer spending and help the economy out of the coronavirus doldrums. Then, at a later stage, tax increases and spending cuts designed to bring back the national budget under control — that would happen at some point in the autumn.

That is at least Sunak’s plan, according to several U.K. media reports. The strategy isn’t yet official, and it may have been leaked as a trial balloon, to gauge markets’ and public opinion reaction. But in the form it is currently described, the plan makes little economic sense.

Take, to begin with the VAT cut. It would be hailed by many industries — think retail, the hospitality business or tourism — where prices would be expected to fall. And it has been tried before, even recently in the fight against the virus’ consequences. Germany last month cut its standard VAT rate from 19% to 16%, on a temporary basis, to stimulate consumer spending.

But there are many caveats here. The first is that the impact on prices — and on spending — depends on businesses passing through the tax reduction onto their customers — as opposed to using it to beef up their profit margins.

The second is that if it is temporary, a VAT rate cut tends to bring forward spending that would have occurred anyway — which can be good for the short term but limits the overall economic impact. Finally, such a measure makes the central bank’s job more difficult, by reducing inflation in a period when it is already too low.

It is also worth noting, when comparing with Germany, that the German economy suffers from long-term structural consumer underspending. That cannot be said of the U.K., which, if anything, suffers from the opposite woe.

But assume the VAT rate cut is passed through in its entirety to consumers (in the form of lower prices) and employees (in the form of more jobs or pay rises.) For Sunak, the measure is meant to compensate for the phasing out of his most important anticrisis measure so far: the job retention scheme (JRS), which saw the government pay up to 80% of wages of employees on furlough. It was generous, helped many businesses and people weather the crisis, but as the U.K. economy is coming out of its three-month lockdown, it is time for the government to consider new policies.

According to Bank of America analysts, the VAT cut, however, would have a lesser impact than the JRS on the economy. So the short-term effect will be to reduce the fiscal stimulus.

That would be premature. But then, on top of that, you have to wonder why the government would insist on announcing future tax hikes, and what would very much look like fiscal austerity, so soon.

The economy isn’t out of the woods. The U.K. will be the worst-hit European country by the virus — with gross domestic product down by 11.5% this year in a baseline scenario, according to the Organization for Economic Cooperation and Development.

Rising budget deficits and public debt are a hot-button issue in the U.K., with the ruling Conservatives having long defined their economic policy by strict adherence to fiscal rigor. The fact that public debt has now reached 100% of the U.K.’s GDP made for screaming headlines last week. And the government wants to keep ruling as a vigilant guardian of taxpayers’ money.

But, economists point out in rising numbers, this year isn’t the year to worry about public debt. That is true in Europe and in the U.K. as well. Yields on the country’s 10-year bonds are at record low — a nominal 0.2% — which means that they are negative in real terms.

The U.K. even has a luxury others don’t enjoy: the average maturity of its debt is now nearly 16 years (more than double that of other comparable EU countries). So even in the case of a sudden rise of interest rates, it would take years before it has a serious impact on public finances.

What’s worse, announcing tax hikes in advance will directly counter the current stimulus, as households and businesses tend to save ahead, and reduce consumption or investment, in the expectation that taxes will raise.

“Talking about withdrawing stimulus this soon (…) looks to us like pressing the accelerator and the brake at the same time,” write the BofA analysts. If the government persists in that style of driving, expect trouble on the road ahead.

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