Economists call it the automatic stabiliser. It means that when the country enters a recession and people lose their jobs, two things happen: government income falls because it collects less tax, and its expenditure rises because it is paying out more in benefits. But when a downturn is as serious as this one threatens to be, more than automatic stabilisation is required.
The obvious tactic is to reduce interest rates, and we have a seen a dramatic move in that direction. But interest rate cuts may be less effective than usual in boosting economic growth, both because they cannot be cut far enough and because the banks will not pass them on fully. Something else is needed, beyond the limited acceleration of public works already announced. That something, as of this weekend, is tax cuts.
The Prime Minister disclosed that taxation was in play when he hinted that tax changes could be in the imminent pre-Budget Report. Though precisely what taxes he had in mind, he carefully and repeatedly declined to say. Next up was David Cameron, who as Conservative leader has hitherto steered clear of raising hopes of tax cuts, to the distress of sections of his party. Yesterday, though, he signalled a revived interest in tax cuts as a way of preserving jobs. Suddenly all three parties were talking of tax cuts. The Liberal Democrats, let it not be forgotten, had, as so often in this financial crisis, got there first, promising cuts in the basic rate to help lower- and middle-income households, and planning to pay for it by cutting public spending and blocking loopholes.
The advantage of tax cuts, of course, as all parties realise, is that they can make a more immediate impact than almost anything else, and they avoid the obvious criticism of interest rates cuts – that they help the over-borrowed most. People who find more money in their wage packets will often be persuaded to spend, as they did in the US after the Bush tax cuts earlier this year, bringing the necessary boost in demand.
The problem is that there is no guarantee that people will spend as the Government would like. Instead of buying goods, they may just pay off their credit card debts. That would be good for the medium-term re-balancing of a debt-addicted economy, but it would not provide the short-term stimulus the economy needs. Worse still, the recipients might save it, which is what happened in Japan.
We have probably not yet reached the crisis in confidence that would convince the public to sit on the extra cash from tax cuts. But the key issue will be, if there are to be tax cuts, what kind? VAT is one possibility, which would assist small business and the low-paid, but a lower VAT rate would get Britain into trouble with the European Union. More effective perhaps than an across-the-board cut, however, might be cuts, through adjustments in child benefit and tax credits, which redistributed income towards the less well-off. It could be the Government's last chance before the next election to claw back progress towards its child poverty targets. And it would put the money in the pockets of people who are likely to spend it immediately.
Mr Brown should not be timid on this. He needs to do something big and bold enough to make a noticeable impact on the economy. But this must be done in the context of assuring the markets and electorate that this is a one-off. The age of fiscal responsibility will have to return as soon as the economy recovers. Then taxes are bound to rise. Whatever the Government decides in the coming days, we will be paying for this mess well into the next decade.Reuse content