VAT’s not looking too good

The BBC reported today that, according to the latest figures from the Office of National Statistics (ONS), the UK economy shrank by 0.5% in the last quarter of 2010. This comes with a particularly large contraction in the construction industry.

Of course, a lot of blame has been placed on the bad weather, resulting in worse than expected retail sales over the Christmas period. This may be true, but note from the graph that the UK had made it out of recession at the end of 2009 and was beginning to recover (for the most part) in 2010. The rise in VAT rates from 17.5% to 20%, among other policies, looks like the government is kicking the economy back down just as it is about to stand up.


After a recession, the idea is to get the economy expanding again. Recessions – the low point of an economy’s business cycle – are usually typified by a sharp increase in unemployment.

I plotted the above graph using ONS figures for ILO unemployment. The unemployment rate seemed fairly steady throughout 2007, and began to rise in Summer 2008 when Lehman Brothers collapsed.

Consistent with the economic growth data, the unemployment figures show a stabilisation towards the end of 2009, at around 8% – quite a high proportion of the workforce. I suspect it may be on a slight upwards trend once the figures for the end of 2010 come in.

What does all of this mean?

All of this suggests that a key focus for current policy should be to get people into employment. This should then help to increase consumer demand, and therefore expenditure, especially since interest rates are still low (for now anyway… more on this in a future article).

However, as the BBC reports, the Chancellor George Osbourne seems to be fine carrying on his policies of very steep cuts to the public sector. Clearly, this isn’t going to help the unemployment situation.

But we can still rely on people spending more in 2011 to get the economy moving again, right? Well, the rise in VAT rates from 17.5% to 20%, just as the economy was seeing the light at the end of the tunnel seems to have squashed all hope of that. And with inflation creeping higher and higher, wages will either have to increase (creating a vicious cycle of yet more inflation) or people will have to take substantial real wage cuts. This will surely kill consumption in 2011.

Of course, it’s easy to criticise, but the budget deficit is still at unsustainable levels. It is inevitable that some tightening must happen. However, immediately jumping in to cut jobs and discourage spending at a time where the economy is in a fragile state appears to me to be a grave mistake. I really hope that we don’t live to regret it.

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