VAT: the inflationary fiscal contraction

Plenty of us are worried about George Osborne’s doctrine of ‘expansionary fiscal contraction’ – that as he cuts public spending and raises taxes, the economy will not weaken but strengthen.

His theory is that the financial markets will ease as the government borrows less, so that businesses and households will be able to borrow more cheaply and thus spend more, because the now perfectly healthy banks have oodles of spare money to lend and the last few years have absolutely not made any of us debt-averse. This will boost growth and certainly not store up any kind of trouble because rising private debt never leads to economic problems. What’s more, by laying off hundreds of thousands of its own workforce, the government will free up productive capacity and stop ‘crowding out’ our frustrated private sector, which has been desperate to hire more people but just can’t find anyone who’s unemployed.

Well, maybe. But I’m thinking about yesterday’s inflation figures. CPI is up to 4.5%, well above the 2% target, and it’s expected to go higher. As Duncan notes, without the effects of the VAT rise and other indirect taxes, inflation would be a more manageable 3%. Three-fifths of the above-target inflation is the government’s fault.

Pretty much all tax rises slow the economy down. Mostly, they also reduce inflation, as producers and retailers adapt to lower demand by cutting prices. But the government has discovered the ingenious double whammy of a tax hike that raises prices as well as hitting growth: an inflationary fiscal contraction. Both of these things are bad in themselves, but there are two further bad consequences.

First, the combination of them makes life very hard for the Bank of England. Inflation is way above target, but interest-rate rises – the tool for reducing inflation – are risky given the weakness of the economy. The theory was that loose monetary policy could offset ever-tighter fiscal policy, but with fiscal policy creating higher inflation, the Bank will probably have to put rates up sooner rather than later.

Second, state pensions and a number of benefits are linked to inflation. Putting up VAT is supposed to reduce the deficit, but the resultant higher inflation means that a fair amount of the money raised will just end up being paid out again: as a revenue-raiser, it’s inefficient. This will mean the deficit stays higher for longer – unless Osborne, who takes pride in refusing to budge from his Plan A, tightens further still.

Lucky us.