What if VAT is cut?

One of the main expectations from this afternoon's pre-budget report is of a temporary cut in the rate of VAT. If true, what effects will this have?

• Creating extra work for accountants and software developers. This would be the first change in VAT since 1991, and the economy is a lot more complex and automated than it was then. My own programmers are on standby to update and check all our clients' systems if the change goes ahead. We are hoping to have a few days' or weeks' notice of the change so that we have time to do this. Accountants, similarly, will have some extra work to check that their clients have changed the rate they apply and correctly dealt with invoices which might straddle the effective date of the change.
• Administrative overhead for retailers. There will be work for retailers in changing prices - and particularly in reconsidering non-granular price points such as £1.99 or £5. Many retailers may not reduce prices but will increase profit margins instead. The retail sector has been under a lot of pressure so there will be strong temptation to hold at least some prices. No doubt consumer bodies will be active in monitoring these prices so it will be interesting to see how the fights play out. Perhaps this will make pricing a more visible issue in the public realm.
• Reduced cash float for most businesses. On balance, companies hold their net VAT receipts for about ten weeks after collecting it from their clients and before paying it over to the government. A typical service business turning over £1 million and spending £200,000 on taxable items will currently collect £140,000 a year in VAT, holding an average of £28,000 as cash float. The size of float will vary from about £11,000 to £46,000 over the course of a quarter, meaning that £11,000 is a permanent interest-free loan from the government. If VAT is cut to 15%, the average float will reduce to about £24,000 and the permanent component to £9,500. In an environment where credit to companies is being cut back, this may make an appreciable if small impact. The amount of the effect on average float is only 0.5% of value add, so this will not be critical for most businesses, but it doesn't help.
• Subsidy for ex-EU businesses buying services in the UK. Most businesses are VAT-neutral so their own finances will not be directly affected by this change. The three types of entity which actually pay VAT are consumers, microbusinesses under the VAT threshold, and non-EU companies. Occasionally we have sold software services to a US or Canadian company, and if the service is provided in the UK, they pay VAT on it. They will now pay less.

Of course, these are all minor second-order effects. The real impacts is to increase disposable income for consumers. A VAT cut of 2.5% - if passed on by retailers - means an average of about £600 of extra income per household - £50 per month.

If this is all spent, it should boost GDP by about 1%; if it is all saved, it should increase private saving by maybe 20%, reduce the outstanding stock of debt and perhaps be made available for business investment - all of which support future GDP growth. If it is spent, it should have a multiplier effect which will eventually increase business investment too. So the effect should be positive, and the question becomes whether it is positive enough to outweigh the cost of paying back the public debt in later years.

Opinions on this vary, to say the least. Nigel Lawson's article in today's FT argues that Keynes was wrong, fiscal boosts do not work, and this money will be wasted. Greg Mankiw on the other hand thinks the benefits of the boost have been underestimated, and that a multiplier of 2.0 should be applied to calculate the GDP benefits of deficit spending.

My view is that the long-run boost depends on the effectiveness of the investment. Japan wasted lots of money in the 1990s running a deficit, and hardly grew its economy at all. But if investment goes into the right places, it undoubtedly increases productive capacity and, in turn, levels of demand. Keynesian boosts have the convenient feature of allowing both to happen at once, under certain circumstances.

So is the UK economy good at allocating investment to productive ends? The government is trying to make it better, by increasing credit availability to small businesses. This does rely on the assumption that smaller companies are better at investing; that isn't clear, though I'd like to believe it is true on balance. I will include this question in the ongoing research at Intellectual Business.