Buttonwood’s notebook | Fiscal policy, economies and markets

The gamble

Another government tries to cut its deficit with a consumption tax

By Buttonwood

JAPAN 1997. That is the awful warning for governments that attempt to tackle the deficit by raising the consumption tax. The rise is generally agreed to have killed off a promising recovery.

The new British chancellor George Osborne is unabashed. He has announced a rise in VAT from 17.5% to 20% as of January next year. The shift is understandable on one level; sales taxes are very easy ways of raising revenue. In contrast, the cuts in public spending, which have impressed the markets in the scale of their ambition (departmental budgets will fall 25% in real terms) will be very hard to acheive in practice.

Delaying the VAT hike may advance some spending from 2011 into 2010 but this is akin to the US housing tax break and cash-for-clunkers subsidy. The worry is that spending may slump next year and stay down; that is what happened in Japan, and in Germany in 2006 after a similar move and indeed in the UK when VAT was nearly doubled in 1980. Of course, a shift from consumption to investment in the medium term is a good thing.

The average voter will see prices go up next year and if he or she is a public sector worker will have their pay frozen as well. The cuts in benefits will fall on those individuals who have a high marginal propensity to consume. Meanwhile "middle England" will see more of its salary taxed at 40% (higher rate tax relief is being frozen). The rich were already clobbered by Labour and they are not getting any relief.

Alas, this is what austerity feels like. The Greeks and Irish have had their go, and now it is Britain's turn. We know that individual countries have cut their way to health. Canada in the 1990s is the example most referred to in the British press. but Canada had its success in the mid-1990s when its neighbour in the US was booming. Britain's biggest market is Europe. What happens when lots of countries put on a hair shirt at the same time? It is a gamble.

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