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Business Comment

David Prosser: A VAT cut is worth it – even for those who worry about the deficit

Outlook For those who believe the deficit is the absolute priority for economic policymakers, the call by Ed Balls yesterday for a temporary cut in VAT was never going to play well. Predictably enough, within hours both David Cameron and Nick Clegg were rubbishing the proposal in terms with which we are all now familiar – "maxing out the nation's credit card" and so on.

That's a pity because the thing about cutting VAT is that we know it works – and it will not cost anywhere near the theoretical £12.5bn price tag of a 2.5 percentage point reduction in the standard rate.

We know this because a temporary cut in VAT was exactly the policy pursued during 2009, when the UK was mired in recession. Despite widespread prior scepticism about its effectiveness, the figures show that it did have a very positive effect.

According to analysis from the Centre for Economics and Business Research, an independent think-tank, consumers spent as much as £9bn more than theyotherwise would have done during the 13 months for which the VAT cut ran. As a result, retail sales growth accelerated during the downturn rather than collapsing.

All of that extra spending was VAT-able, of course, so the net cost of the reduction was significantly smaller than expected. And that's before one starts to count the wider economic benefits – retail jobs saved, for example – of the spending, which will have produced additional tax revenues.

Fast forward two years and the argument for a return to thispolicy is that it is the consumer-facing sectors of the economy that are finding the going hardest during this anaemic recovery. The squeeze on household incomes from inflation, Government austerity and muted earnings growth means there is little prospect of any respite in the second half of the year. Yet a VAT cut would produce exactly that.

In his Mansion House speech on Wednesday evening, the Chancellor was at pains to reassure people that he intended to cut the 50p top rate of income tax as soon possible. Mr Osborne's view is that income tax rises do not necessarilyproduce more revenue, because people find ways round them, or simply lose their motivation for enterprise. The reverse is true of income tax cuts, he adds.

If this is true for direct taxes, why does it not apply to indirect levies such as VAT? The CEBR's research suggested that, as expected, the last VAT cut stimulated spending. It seems logical that the VAT increase Mr Osborne introduced in last year's emergency budget will have had the same effect since coming into force in January.

Even Britain's most ruthlessly efficient retailers are now suffering from the squeeze on household incomes – look at Tesco's latest numbers, published this week. To those that are really struggling, a VAT cut might be the difference between survival and bankruptcy, but the effect would be positive across the whole consumer sector.