We may have to cut taxes, not put them up

It seems the tax rises in the Budget may have had a more serious effect than the Treasury expected
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The Independent Online

Are the world's consumers going on strike? And if so, is it better to cut interest rates or cut taxes to get them moving again? For on their spending, the health of the world economy turns.

There is an ominous mood in the financial markets following the news this week that two huge consumer groups, Unilever and Heineken, are warning of lower than expected demand. Unilever says that sales will rise by only 3 per cent this quarter, which, since there is still a bit of inflation, means about 1 per cent growth in the basic products, such as washing powder, that the company produces. And while beer is arguably a less essential product, Heineken sells much of its output on the Continent, where demand has plunged.

When companies disappoint shareholders, they usually blame market conditions. Unilever cited retailers cutting back on stock, slow perfume sales and Sars. Heineken also blamed Sars, adding the smoking ban in New York, bad weather in the US and Europe and the strong euro. Oh yes, and the French for some reason stopping drinking beer.

Um. You can be cynical and note that whenever companies are doing well it is thanks to the brilliance of their leadership, and please can they have more share options, but when they are doing badly it is because of unexpectedly adverse market conditions. Still, the fact that weak consumption should take these firms by surprise is disturbing - all the more so because it is a global problem that we here in Britain have been slow to notice.

Britons have been unusually cheerful by world standards, maintaining spending while others have faltered. In the US, too, consumers have kept spending despite the rise in unemployment. Yesterday's "confidence figures" suggest that they will keep it up a bit longer.

In Japan, by contrast, consumption has been flat for several years, and in Germany it was down by half a percent last year, and it will be pushed to regain that this year. Only yesterday Italy revealed its lowest level of consumer confidence for six years. Thanks to weak consumption, at least half the eurozone - Germany, Italy and the Netherlands - is in recession.

But we all knew that. What is new is that now there seems also to be a wobble both here and, more importantly, in the United States.

As so often in economics, the evidence is patchy. It would be nice if we could wait until the statistics clearly pointed one way or the other, but by then the damage is done. That is what has happened on the Continent, with the European Central Bank waiting too long before cutting interest rates, and a decade ago when Japan made the same error.

In Britain it seems that the tax rises in the Budget may have had a more serious effect than the Treasury expected. Unemployment rose suddenly last month, which may be a blip, but it came just as the rise in national insurance contributions hit company accounts.

Shops in central London are having a terrible time, but it is hard to distinguish if this is the result of the fall in tourism, high-earners pulling in their horns or simply a reaction to the congestion charge. My guess is that what we spend will be determined largely by house prices. If they come off sharply, we will cut back our spending. Largely but not entirely; if house prices are stable but taxes rise sharply, we could also be forced to make cutbacks, as some people already are doing.

In the US, the picture is equally cloudy. This has been the slowest recovery from recession since the Second World War, for every time growth seemed to be getting going, it stalled. It has also been the one recovery that has not been accompanied by a fall in unemployment. But the very latest data has been more cheering, which raises the question: why is the Federal Reserve going to cut interest rates later today?

US rates are already very low - just 1.25 per cent - but everyone expects a further cut, either to 1 per cent or even to 0.75 per cent.

Now you might reasonably ask: what is the point? If money is so cheap it is not going to make a whole lot of difference if it becomes even cheaper. That certainly has been the Japanese experience. Maybe the Fed is more worried that it has let on, maybe it wants to get credit for a recovery that was already in the process of happening, or maybe it simply does not want to be blamed for inaction.

At any rate a grand experiment is taking place around the world with different countries trying in different ways to get or to keep consumers moving.

In the US, the policy is very cheap money and a series of tax cuts mostly directed towards the rich - this is a Republican administration, after all.

In Japan it has been even cheaper money than in the States, coupled with large increases of public spending financed by borrowing. These policies have been almost completely ineffective, as the Japanese have offset all attempts to increase demand by saving more and more.

In Germany, there has also, until recently, been policy paralysis, partly because of membership of the eurozone and Europe's Growth and Stability Pact. But now Chancellor Schröder and his finance minister Hans Eichel are also trying to push through tax cuts. If they succeed the top tax rate in Germany will, in theory, come down to some 42 per cent - only a whisker above the UK's present 41 per cent. I say in theory because there is in addition a "solidarity" tax to help the former East Germany - but you see the argument. Germany reckons that the best way of stimulating its economy is to cut tax on high earners to British levels.

This makes an intriguing backdrop to the latest argument about tax here in Britain. We have had an extraordinary consumer boom, with living standards over the past 10 years rising even faster in Britain than they have in the US. We have not had a problem of lack of demand, rather the reverse.

But now the world is changing. The Japanese disease of falling prices and weak demand has clearly spread to Germany and other parts of the eurozone. The Fed is frightened it will spread to the US. Everywhere interest rates are being cut to a level where, for banks at least, it is virtually free. Of course, when they have added their charges and earned their margin it isn't free to the borrowers, but historically it is still very cheap.

Maybe this will work. Let's hope so, because another leg to the downturn is not going to be fun for anyone. But if cheap money fails - and it has failed in Japan and been rather ineffective in the States - then it is clear what the next weapon has to be. It is tax cuts.

Tax cuts do not rank high on the priorities of the present Government because it has not had to face the problem of lack of consumer demand. It has been facing in the other direction: trying to find money to spend on public services.

But times change. Five years ago people still worried about inflation. Now they worry about deflation. A year ago, everyone was worried about the housing boom. Now people are worrying about a housing bust. If British consumers, like those elsewhere in the world, really catch the jitters, then we could suddenly find that too little personal spending, not too much, is the problem. Then there would be the curious prospect of Gordon Brown forced to bring in tax cuts to try to persuade people to spend a bit more. That would be quite funny, wouldn't it?