David Prosser: Rethink policy on VAT before we hit a trough

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Outlook Seven weeks and counting to the moment when Britain's value-added tax rate leaps from 17.5 to 20 per cent. The reasons to consider delaying the hike (or dropping it altogether) stack up by the day.

The obvious worry is that cash-strapped consumers will not be able to cope with higher prices, undermining the tentative recovery of industries such as retail. The mixed bag of results we have seen this week from the high street underlines just how difficult many retailers are already finding it to persuade shoppers to part with their money. The VAT increase will only add to the pressures.

The second problem is inflation. The Bank of England's Monetary Policy Committee (MPC) continues to struggle to bring inflation back down to its target of 2 per cent – yesterday's data reveal the rate to be going up rather than down. The Bank's latest Inflation Report, published last week, suggested this is a trend likely to continue for much of 2011 – and that January's VAT increase will be one of the most significant factors.

One of the reasons the MPC professes itself relatively relaxed about inflation is that the VAT shock is a one-off, rather than a continuing problem. However, one effect of raising VAT will be to make it harder for the MPC to put inflation concerns aside as it considers whether to provide new stimulus to the economy in the form of a return to quantitative easing.

The VAT rise is, in that sense, a double whammy. Not only will it do damage to parts of the economy, but it will also make it tougher for the MPC to counter the damage.

The counter-argument is the one George Osborne would presumably adopt: that higher VAT is not desirable, but that in these indebted days, additional tax revenues must be found somewhere. True, of course, but will VAT really come to the Treasury's rescue? Alan Pearce, a VAT specialist at the accountancy firm Blick Rothenberg, warns Mr Osborne not to get his hopes up. VAT is the tax that produces the biggest shortfall between what the Government expects to collect and what actually comes in, he points out. A rise in the VAT rate is likely to widen the gap, as more people seek to avoid the tax by using the black economy.

To sum up: this VAT increase will raise the chances of a double-dip recession, limit the options of the Bank of England to respond, and fail to raise the revenues hoped for. Time for a rethink?

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