Shopping Beats Working?

In case you hadn’t noticed, Chancellor Alistair Darling’s giving a bit of a speech this afternoon.

He’ll be laying out the Government’s plans for saving the economy from an even worse recession than it’s already facing.

It’s quite a clever way to sell it. Regardless of how bad things get in the future, you can always say: “Well, it would have been even worse had it not been for the quick-thinking actions of the dynamic Brown Government.” That’ll be the spin anyway.

But can the pre-Budget Report really make much difference to our economic plight? Of course it can. It can make things a lot worse…

This government encourages shopping and discourages working

The main thrust of the pre-Budget Report seems likely to be a 2.5 percentage point cut in VAT, which will fall to 15%. There’s plenty of other stuff being mulled over by the papers, and no doubt a few nasty surprises as well. But we’ll find out what he’s really got in store for us in a few hours, so no point running through all the eventualities here.

Let’s just focus on this VAT cut. I’m not going to complain about tax cuts. Lord knows, we’ve seen too few of them in the past decade. But it’s interesting to have a look at the thought process behind what’s being done here.

VAT is a tax on consumption. As taxes go, it’s not the worst one. It treats everyone equally and fairly - you pay according to the quantity of resources you consume. You could even describe it as a green tax.

Income tax, on the other hand, is a tax on production. The harder you work, the more you earn. The more you earn, the more the state takes out of your pay packet. And oddly enough, this effect is felt most strongly among the least-well off in British society. Because of the way the ridiculous tax credits system works, certain workers face a marginal tax rate of 70% once they earn above a certain amount. In other words, there’s a point at which they only end up getting an extra 30p for every £1-worth of work they do. For an apparently dour Presbyterian, Mr Brown sure doesn’t believe in encouraging the work ethic.

So effectively, the Government heavily favours consumers over producers. And the pre-Budget Report makes this very clear. Because it’s tomorrow’s producers who will pay for today’s consumer boost. According to The Daily Telegraph this morning, Labour plans to introduce a 45% tax rate on those earning above £150,000 after the next election.

Yet Britain’s big problem is that we’ve been doing too much consuming and not enough producing. How does encouraging more consumption, and discouraging production, help us get any further forward? The answer is simple enough. It doesn’t.

A recession is nature’s way of telling you that your economy is heading down the wrong path. A depression is nature’s way of saying the same thing – only a lot louder.

Britain needs a new set of economic props

As a nation, we’ve become too dependent on three things, all of which have been fuelled by the credit bubble. First there’s the financial sector. The finance sector is meant to allocate capital efficiently. It gets money from the people who have it, to the people who need it, with a minimum of fuss. That’s the nature of the value that it adds to the economy. But it’s not performed that role anywhere near as efficiently as we’d like to pretend. Were all those new-build buy-to-let properties an efficient use of capital? No, I don’t think so either.

The financial system’s ability to allocate capital efficiently has been badly undermined by central banks making it much harder to gauge risk clearly – more on that in the future. In any case, the end of the credit bubble also spells the end for the consumption bubble.

People used easy money and grossly inflated house prices to boost their consumption of everything from household furniture to shoes to computer games. That in turn meant more jobs in the services sector. But now that economic prop is being kicked away too.

The third prop has been rampant government spending. Fuelled by cheap borrowing and extremely healthy tax revenues, the government has splashed our money all over the public sector. But it’s not been spent on useful jobs, but on increasing the range of administrative and management roles in health, policing and education.

What will replace finance as our 'specialism'?

What can we do about all this? We need to consider what will replace the financial sector as our ‘specialism’. If we want to maintain a developed world standard of living, we need to contribute something to the global economy that can sustainably generate high-paying jobs. That means we need to have well-educated, skilled employees. But given the Government’s propensity to view any institution that promotes academic excellence with suspicion and hostility, the chances of turning around our education system any time soon is a major challenge.

And right now, this is a debate for another day, argues the “something must be done!” brigade. So will the VAT cut be effective? Well, it’ll make goods in the shops cheaper. But then, so will deflation. Shops are already slashing prices ahead of what they fear will be a miserable Christmas. And consumers are – rightly - already in ‘cut-back’ mode. It’ll take a lot more than a couple of percentage points off prices to make them blow their budgets this year.

So Mr Darling will have to have a lot more in his box of tricks if he wants to make a dent in this recession. We’ll find out soon enough – and give you the reaction on the MoneyWeek website later this afternoon.

Big Thank you to John Stepek