Wednesday, January 5, 2011

UK VAT rise permanent

or so says the Chancellor.

That is exactly what he should say - even if it is not permanent. Why? Because if people know VAT will decline, spending will fall by more than it would if people believe it to be permanent as consumers will wait for prices to fall.

It is for the same reason as deflation is bad. If prices are believed to be falling, then why buy anything now? Rather wait till prices are lower. But then, of course, demand is very low, resulting in low production, resulting in fewer jobs, resulting in genuinely lower demand and so a viscous cycle begins.

In fact, if consumers think prices will fall, the Government could pump money into the economy - say, through quantitative easing - but demand still won't increase - we could call it a liquidity trap. Japan got stuck in one.

The result is that the Government might actually collect less tax revenue rather than more, which is the aim of the tax hike.

Of course, consumer spending may still fall somewhat as prices have risen, but hopefully the Government will collect more tax, preventing public services spending cuts from falling as much as they would have. Ignoring the impact on borrowing and savings (household and Government) it is just a switch from private spending to Government spending. Albeit that the total is slightly lower level more in line with actual UK productivity, rather than borrowing to consume the production resulting from the hard work of other people.

1 comment:

  1. Terrible those viscous cycles aren't they - very sticky.... ;-)