The economic risks hiking VAT

This slide in our briefing yesterday, from David B. Smith's speech, is very important.  It reports provisional findings from the Beacon Economic Forecasting Quarterly Macroeconomic Model of the UK and International Economies (BEFMOD):

Many people work on the assumption that the economic effects of a VAT hike will be relatively benign.  While they worry about the politics and the effect on the poor, they think it won't do much harm to the economy.  If the results David B. Smith has produced are right, that assumption is very wrong.  Hundreds of thousands could be out of work, national income could be lower and government borrowing (PSNB) higher as a share of national income.

We have to hope that the Government wouldn't have put up VAT if it thought that it would lead to these results shown on that slide.  So why would the BEFMOD come up with different results to the Treasury model?

We recently released a research note based on BEFMOD results, looking at the likely effects of a rapid fiscal adjustment through spending cuts - followed by tax cuts down the line.  The model has been developed over
decades and for 2006 was rated the most reliable model of the British
economy by the Sunday Times. Our research note included a description of some of its key distinguishing features.  These two probably explain why it finds that VAT is more economically harmful than the Government might have thought:

"Buffer-stock monetarism. BEFMOD has always incorporated the theoretical approach known as ‘buffer-stock’ monetarism, meaning that more attention is paid to the broad money supply both internationally and in Britain than is usual in other UK models. This means that BEFMOD’s theoretical framework is closer to that of the European Central Bank’s ‘second-pillar’ approach than the Conventional Theoretical Macroeconomic Model (CTMM) widely employed by Anglo-Saxon economists, which ignores money entirely.


Supply-side economics. BEFMOD has also attempted to embody the insights arising from supply-side economics, particularly the importance of the tax burden as an influence on economic decisions with respect to output, the size of the tradables sector, private-sector employment, the exchange rate and prices."

So it takes the role of the money supply and tax policy relatively seriously.  What is interesting is that monetarism and supply-side economics are normally associated with conservative economic thinking, on both sides of the Atlantic.  A Conservative Chancellor of the Exchequer, like George Osborne, should definitely take a model based on this approach seriously as another perspective to that on offer from the Treasury.

If the BEFMOD results are right, then hiking VAT was a serious mistake.  The coalition are taking a huge risk with no mandate and the public overwhelmingly opposed to the measure (as a new poll from the Sun has made clear once again).

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